The impact of index investing on market efficiency can be examined from first principles. The beginning sections of this post provides a brief summary of posts by researchers at O’Shaughnessy Asset Management. There is a view in the investment community that indexing makes the markets less efficient and is fundamentally unsustainable. In this post, we argue against that view, showing not only that indexing is sustainable, but that may in fact make markets more efficient over the long run.
Conservation of Alpha
Consider the entire universe of financial assets and divide investors into active and passive segments; let each investor start with the same portfolio. After some trading period, the passive investors still hold that initial portfolio, and the active investors, in aggregate, end up holding the same portfolio—so both groups achieve equal returns. This occurs because passive investors, by definition, do not trade with each other, and active trading is zero‐sum when benchmarked to the universal portfolio. Therefore, in frictionless markets, the aggregate performance of active investors always equals that of passive investors. Alpha (excess return over the market) in the active segment must, by definition, sum to zero across all active participants over any given period.
Index Fund Flows & Share Buyback / Issuance
It’s important to note that “passive” has meaning only relative to a chosen portfolio—in our earlier example, that universe was all securities. A truly passive strategy within a given universe requires no trading when prices move. By contrast, value, momentum, and fixed-allocation strategies all need periodic rebalancing to maintain their defining exposures.
Consider an S&P 500 index mutual fund that receives a cash inflow. For a moment, it’s no longer passive relative to the S&P 500—it holds cash, not shares—so it must trade cash for index shares to restore its passive stance. During that adjustment, it behaves like an active trader. If its inflow exactly offsets outflows elsewhere in another S&P 500 fund, there’s no net market impact, but uneven flows force “passive” funds to trade with active liquidity providers. Whenever a passive investor crosses the bid–ask spread to trade with an active counterparty, one side wins and the other loses. The Law of Conservation of Alpha holds only once the passive portfolio is fully assembled; trading to build or dismantle that portfolio is inherently active.
A similar forced interaction arises with equity issuance and buy-backs. New share issuances—whether via IPO or secondary sale—expand the universe, compelling passive holders to buy additional shares (typically from active market makers) to stay fully invested and creating timing mismatches that can drive performance divergence. Buy-backs reverse the process: a company retiring shares forces index funds to sell down their positions, then reinvest the proceeds elsewhere in their portfolios. In both cases, net flows into passive vehicles—and net changes to the investable universe—are the only drivers of performance divergence between the passive and active segments of the same market.
The Universe of Securities
The theory of the conservation of alpha is an accounting identity that is true by definition. Yet we observe data suggesting that active funds have underperformed their passive counterparts by amounts far exceeding trading and management costs.
It’s important to note that when investors refer to “the market,” they almost always mean the S&P 500. But active hedge funds routinely hold non-S&P 500 securities—small-caps, foreign equities, and cash to meet redemptions. In an environment where the S&P 500 has dramatically outperformed other asset classes, it’s unsurprising that hedge funds would lag behind.
In an essay by Neil Constable and Matt Kadnar of GMO, the authors build a three-factor model using those asset classes to demonstrate that active managers’ outperformance (and underperformance) relative to the S&P 500 is largely explained by their exposures to small-caps, foreign equities, and cash.
We will return back to the discussion about investing outside the index later, but for now we assume that we are talking about investing within the index.
Liquidity Provision
From our analysis of passive flows, we see that an amended version of the conservation-of-alpha equation can be written as:
Active Returns = Passive Returns + Liquidity Provision – Research & Trading
In equity markets, the fact that passive ETFs can easily track indices with negligible liquidity costs suggests there is too much active trading. Indeed, a quick Google search shows that the vast majority of active managers in large-cap equities underperform the benchmark over the long run.
Using the equation above, we can estimate how much of large-cap US equities “should” be actively managed. Assume the average annual change in S&P 500 composition is around 10% (typically much less). An upper-end estimate of trading costs for a passive investor might be 1% (usually much lower). If an active manager charges 2%, then at equilibrium—where an investor is indifferent between active and passive—there will be roughly twenty times as much capital passively managed than actively managed.
In fixed-income (nearly three times larger than equities by market size), however, turnover is much higher, simply because bonds mature while equities represent permanent capital. Research shows that an investment-grade index has a 49% turnover rate, and high-yield around 93%. Passive trading costs here are higher, and unlike equities—which naturally increase exposure to winners—bond indices passively expose holders to the most heavily indebted issuers. These factors suggest active managers are more likely to outperform in bonds than in stocks, and indeed AQR research shows fixed-income managers consistently outperformed their benchmarks, after fees, from 1997 to 2017.
In short, the conservation of alpha applies only within the same universe of securities (it’s unfair to compare hedge funds to broad equity markets), and the liquidity-provision revenues of active managers are non-trivial. While bond illiquidity allows active managers to add value, the deep liquidity of the stock market suggests indexing still has a long way to go before investors should become indifferent between active and passive management across the board.
Market Efficiency and Price Setting
Active investors set market prices. Passive investors can’t set prices by definition, because they don’t trade securities on a relative basis. An efficient market needs active participants to establish prices; accordingly, we find it troubling to imagine markets functioning properly if the majority of investors are passive. However, price efficiency depends solely on interactions among active traders. In the extreme, a single market maker could set the entire market price if everyone else went passive. Thus, efficiency doesn’t require active investors to hold more power than passive ones, only that skilled active investors hold more power than unskilled ones.
There are two basic types of active trades: noise and information. A market’s efficiency hinges on (1) the quantity (how many noise traders and how much capital they deploy) and severity (how irrational their trading) of noise, and (2) the quantity and quality (how rigorous their research) of information traders responding to that noise.
If noise is prevalent and severe but few trade on information, the market remains inefficient, offering significant edges to skilled investors. Conversely, a more efficient market provides less edge for information traders. Raising the general competency of active investors should naturally increase the ratio of information to noise, thereby improving efficiency.
Passive investing raises the average market participant’s skill indirectly in two ways. First, it allows households to index—letting those who would otherwise trade actively become passive instead. Since skilled investors would trade actively to earn profits, we can assume most choose passive strategies because they recognize their lack of skill.
With less noise, the market becomes more efficient. Remaining noise traders—who by definition have negative expectancy relative to the benchmark—face lower return variance when noise diminishes. Information traders also experience reduced variance on their positive returns, boosting their Sharpe ratios and confidence. This activates the second mechanism: as wealth shifts from noise traders to information traders more efficiently, some noise traders will opt to become passive investors instead.
A similar cleansing effect applies across the entire active‐management industry. The growth in indexing comes from underperforming active funds—those more likely to lack skill than outperformers (though a substantial minority of skilled yet unlucky managers will also exit the market). By removing these less skilled managers, indexing raises the average competency of the remaining active funds.
This narrative mirrors capitalism’s basic mechanism: disruptive innovation (indexing over the past two decades) creates a small group of winners (e.g., Renaissance Technologies, Citadel, Bridgewater, D.E. Shaw, Elliott, Millennium, AQR, Two Sigma) while eliminating a larger cohort of losers (active managers forced to close, retail traders who churn). In doing so, it benefits a far larger group of consumers—households that passively invest in broad market indices and public companies.
The ease of outperformance can serve as one measure of market efficiency. It would be absurd to claim that it’s easier to beat a market where the primary counterparties are math PhDs than one diluted by average Robinhood traders.
Indeed, while accurate price signals are vital for resource allocation, an economy doesn’t need a million people arbitraging individual stocks when a few thousand top‐tier traders can do the job. Economic winners will earn outsized rewards, and others will redirect their time and energy to more productive endeavors. Free markets naturally correct inefficiencies, though often over decades. For most people, active trading is an unproductive use of time—passive management is its inevitable solution.
Outside the Index
It’s important to note that passive investing within a given universe makes that universe more efficient; however, unless that universe is literally all investable securities, the investor is still active relative to the broader market. For example, companies aren’t born in the S&P 500—most firms never join that index—so buying an S&P 500 fund “represents an active investment within the universe of all assets.”
Thus, while indexing large-cap equities boosts efficiency in that segment, it can mean other areas are overlooked. In particular, private equity and venture capital have drawn massive flows away from public markets. These two investment methods correspond to two additional functions that active investors serve—beyond (1) providing liquidity to passive funds and (2) ensuring efficient price discovery—namely (3) driving efficient management of firms and (4) conducting due diligence on new opportunities.
Take private equity (and similarly private credit): in theory, it improves governance in entrepreneur- or family-owned firms (note that entrepreneurship and management are different skills) and reallocates capital from underperformers to more promising businesses (a polite way of saying workforce restructuring and asset sales). Over the long haul, a landmark study led by Steven Kaplan of the University of Chicago found:
“Using cash flow data from 598 buyout funds and 775 venture capital funds from 1984 to 2008, the authors calculate the average public market equivalent ratio for each vintage year. They find that buyout funds did better than public markets in most vintage years since 1984. The average US buyout fund outperformed the S&P 500 by at least 20 percent over the life of the fund, or by at least 3 percent per year.”
Unsurprisingly, private equity firms have gained in market capitalization while large asset managers investing primarily in the public markets have lost.
Similarly, long-term studies show that VCs have, on average, beaten the public market net of fees over time. Most firms that receive VC funding fail, but the winner-takes-all effects of technology markets mean that the few successful companies do so spectacularly. The VC industry is therefore at the frontier of capital allocation, with the typical firm investing in only around 2% of the targets it screens.
The same economics that made large-cap public markets more efficient have the potential to lower the cost of equity for private companies as well. The recent acquisition of Preqin by BlackRock—aimed at indexing alternative investments—is the first step toward allowing passive capital to flow into the alternatives space.
In the mean time, for most retail investors—who lack the accreditation, minimum checks, and network access required for private-equity and VC deals—crypto offers a practical alternative for early-stage and high-growth exposure. Through token sales (ICOs, IDOs), decentralized crowdfunding, and tokenized equity platforms, ordinary investors can buy fractional stakes in nascent protocols. DeFi primitives like liquidity mining, staking, and yield farming further let participants earn returns akin to traditional carry at a much lower cost of entry. While crypto carries its own risks—volatility, regulatory uncertainty, and technical complexity—it democratizes frontier investments in a way private markets cannot.
Moreover, crypto’s performance has been spectacular: Bitcoin alone has surged roughly 761% since mid-2020, far outpacing gold’s 47.8% and the S&P 500’s 98.7% over the same period . Even over the past year, Bitcoin climbed nearly 89%, trading above $108,000 as of early July 2025.
The Harms of Indexing
So far we have painted a generally positive picture of indexing as an innovative financial instrument that allows the general public to cheaply share in the growth of the nation’s economy. In general, the expansion of indexing is good up until the point that excessive profits are handed to active investors—but then the excessiveness of profits and the active/passive ratio is controlled by profit-seeking individuals who’ll enter any industry with excessive profits.
However, market structures are not perfect, and they certainly were not designed for massive indexing. There are some real harms to indexing which we now discuss. First, it is helpful to distinguish two functions of capital allocation: (1) directing savings to their best use, i.e. a “search problem,” and (2) ensuring that capital is well stewarded once invested, i.e. a “stewardship problem.”
Both are important, but the search problem matters most in early stages of capital formation, when ideas abound but capital is scarce due to high risk. That situation flips once a firm matures. Large, profitable public companies generate enough cash to cover reinvestment needs, and management makes allocation decisions. The market then serves less as a financing source and more as a tool to optimize capital structure—debt duration, share buy-backs, etc.
This shift makes stewardship more critical. In markets where investors care about company performance, prices both signal how the market views a firm and influence how easily shareholders can challenge boards or affect financing costs. The problem is that stewardship incentives are weak in indexing: a manager who bears the full cost of engagement—research, meetings, voting—captures only a small share of the benefits. A 2017 paper found:
“Index funds have especially poor incentives to engage in stewardship activities that could improve governance and increase value. Activist hedge funds have substantially better incentives than managers of index funds or active mutual funds. While their activities may partially compensate, we show that they do not provide a complete solution for the agency problems of other institutional investors.”
The study showed passive managers avoid proxy contests, refrain from shareholder proposals, and seldom nominate directors. Unfortunately, cheap exposure comes at the cost of engagement. Yet other research demonstrates that companies with more active owners are more innovative:
“CEOs are less likely to be fired in the face of profit downturns when institutional ownership is higher… using instrumental variables, policy changes, and disaggregating by type of institutional owner, we argue that the effect of institutions on innovation is causal.”
When index funds neglect stewardship, a governance vacuum arises, to be filled by entrenched management facing less scrutiny. Without active shareholders pushing for accountability and efficiency, executives can extract greater compensation and perks—paying themselves lavish packages justified as “necessary to retain talent.” They may also allow bloated management structures and higher labor costs that don’t translate to improved productivity or shareholder returns.
This dynamic transfers capital—shareholder value—to a subset of labor (managers and employees). While the extent of redistribution depends on management’s choices, history suggests these shifts primarily benefit those in corporate power, undermining long-term interests of both shareholders and the broader workforce.
Decentralized Finance and Corporate Governance
The four primary purposes of active investors are: (1) providing liquidity to passive investors, (2) ensuring efficient price discovery, (3) stewarding companies through effective governance, and (4) performing due diligence on new opportunities.
The rise of index investing has delivered substantial benefits to retail investors—chiefly low-cost, diversified exposure—and has generally improved market efficiency by cutting noise trading (purpose 2). This “natural selection” has culled less able active managers, leaving a more skilled cohort to set prices. However, when too much capital crowds into large-cap indices, earlier-stage firms may struggle to secure funding (purpose 4). Even more worrisome is the governance vacuum index funds create: their passive model yields weak incentives for oversight (purpose 3), allowing entrenched management to favor executive agendas over long-term shareholder and stakeholder value.
As indexing continues its ascent, we must devise ways to preserve its cost and efficiency gains while restoring robust stewardship. Blockchain’s decentralized-finance toolkit offers promising solutions. By tokenizing passive funds, each share can carry an on-chain governance token that automatically delegates voting power to qualified stewards or DAO-elected representatives. Smart contracts can require a small portion of management fees to flow into a community-governance pool that funds proxy research and shareholder proposals. Furthermore, it is possible to deploy architectures where users who stake tokens in oversight DAOs earn additional yield, aligning economic rewards with active engagement. Continuous on-chain dashboards provide real-time transparency into fund voting records, ensuring passive vehicles cannot hide behind opacity.
By embedding these governance primitives directly into passive-index smart contracts, we can recreate the missing incentives for stewardship without sacrificing indexing’s low costs and broad access—bridging the gap between passive investment and active corporate oversight.
Disclaimer
The information provided on TheLogbook (the "Substack") is strictly for informational and educational purposes only and should not be considered as investment or financial advice. The author is not a licensed financial advisor or tax professional and is not offering any professional services through this Substack. Investing in financial markets involves substantial risk, including possible loss of principal. Past performance is not indicative of future results. The author makes no representations or warranties about the completeness, accuracy, reliability, suitability, or availability of the information provided.
This Substack may contain links to external websites not affiliated with the author, and the accuracy of information on these sites is not guaranteed. Nothing contained in this Substack constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. Always seek the advice of a qualified financial advisor before making any investment decisions.
