Passive investing enjoyed another strong year in 2024, with inflows to the sector far outpacing those of their active counterparts – and the ongoing dominance of the US technology sector clearly supporting performance. Nevertheless, as professional investors look ahead, there are a number of factors that should at least make them pause for thought on whether passive funds can repeat the trick in 2025.
October 2024 was the best month ever recorded for ETF inflows, according to Morningstar data, as exchange-traded fund (ETF) and exchange-traded commodity (ETC) products garnered €27.3bn (£22.6bn) between them. That brought the total for the year to €188.3bn – putting it €30bn ahead of the best year ever, with two months still to go.
There is no great mystery to the success of passive investment: investors simply have not felt the need to look elsewhere given that the major indices, such as the S&P 500 and MSCI World, continue to be driven by the strong performance of mega-cap technology businesses – most notably the so-called ‘Magnificent Seven’ of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
‘Magnificent’ by name …
The impressive run of such stocks has become integral to the passive investing story and is likely to be important again in 2025. The way passive works, of course, as any stock goes from strength to strength, it becomes a larger share of its parent index and in turn helps push that index’s returns higher. This helps further the case for passive over active – and the whole cycle starts again.
While the performance of individual technology companies has had some lows as well as highs in recent years, the aggregate performance remains impressive. According to CNBC data, the CNBC Magnificent Seven index rose 54.5% over the first 11 months of 2024, following a separately astonishing year in 2023 that served to render the brief wobble in 2022 ancient history. The strength of AI pioneer Nvidia, in particular, has helped keep the technology sector in the headlines.
Even so, some cracks are starting to appear. By the end of November 2024, according to S&P Global data, the concentration of the top 10 stocks in the S&P 500 index was sitting at just shy of 35%. The previous peak, according to Morgan Stanley, was 30% in 1963 – while, as recently as 2014, the level was just 14%. A similar phenomenon is being seen in the majority of global indices, including the MSCI All Country World index, where concentration has more than doubled in a decade.
The ‘Nifty Fifty’ bubble and Dotcom bubbles are two textbook examples of how market exuberance can play out.”
History suggests this story seldom ends well – the ‘Nifty Fifty’ bubble of the late 1960s and early 1970s and the late-1990s Dotcom bubble being two textbook examples of how market exuberance can play out. Still, as JOHCM Global Opportunities fund manager Ben Leyland points out, the giant tech companies have been successful for a reason. Nvidia’s success, for example, has been underpinned by strong revenues and cash generation. With its P/E ratio rising from 51.5x at the start of 2024, to 63.5x by the end of November, it is worth noting a lot of the company’s share price expansion has come from earnings growth.
‘Acute’ concentration risk
“The US equity market remains near its highest level of concentration in 100 years,” warns Goldman Sachs in a recent strategy paper. “With the performance of the S&P 500 index strongly dependent on the prospects of a small number of stocks, passive allocations to US large cap indices may pose risks to broader portfolios. However, despite acute equity concentration risk, the US equity market remains one of the most attractive in the world due to the US’s resilient economic growth, persistent corporate earnings growth and a strong culture of promoting innovation.
“As the market calls for broader participation, a well-rounded and differentiated approach to investing in the US large and mid-cap space in 2025 may lead to positive return outcomes.” The paper goes on to highlight financials, small-caps and global dividend-paying businesses as the potential winners for 2025 as it expects earnings growth to broaden beyond the Magnificent Seven, beyond the US and beyond large-cap stocks.
This is already happening to some extent. While passive investors were well-served by the returns in the technology sector in 2024, there were also signs of market leadership broadening and diversifying over the year. Within the US market, for example, the top-performing sectors over the first 11 months were utilities, up 29.3%, and communication services, up 27.9%, according to S&P Global. At the same time, utilities and communication services accounted for just 2.5% and 9.1% of the S&P 500 respectively. Financials also did well, driven by a surge in banking stocks, rising 25.2%.
“Don’t get me wrong, many of the Magnificent-7 are fantastic companies,” says Duncan Lamont, head of strategic research at Schroders. “The point I want to emphasise here is not that they are bad investments – just that it is short-sighted to suggest they are the only good investments.”
China effect
The arguments for and against passive in 2025 are more nuanced elsewhere. Among emerging markets, for example, the MSCI Emerging Market index outpaced the average fund in the IA Global Emerging Markets sector – notching up 11.7% versus 7.9% to the start of December.
This may have been the China effect: many active managers had moved to an underweight position in China following its grim performance over the last three years, which meant they did not participate in the rally that followed the announcement of a stimulus package in September to the same extent as passive investors. China remains 27.4% of the MSCI EM index and its largest weighting.
In the UK, meanwhile, a tentative rally from higher-quality small and mid-sized companies helped boost the performance of active managers relative to passive. The average UK equity income fund was up 9.8% over the year to the start of December, for example, while UK All Companies fund was up 9.2% – both ahead of the 7.2% return from the FTSE 100.
Flows are a further consideration. If flows keep moving towards passive funds, that would continue to support the sector – and, at first sight, it would appear ‘business as usual’. In the UK, for example, tracker funds attracted £1.68bn in September (and £2,47bn in August), compared with £963m in September 2023. This was at a time when overall flows were -£ 3,402m in September, £806m in August and -£4,679m in September 2023 respectively.
Yet there are tentative signs of a shift. The most recent fund flows report from LSEG Lipper found passive vehicles suffered redemptions of £2.51bn in October while active funds attracted £3.66bn. This is the first time in recent history that fund-flows data has suggested a shift might be possible. That said, it is still early days – and, as in the last two years, much will depend on the ongoing fortunes of the technology giants.
