A crowded trade is defined as a position characterized by a high concentration of institutional investors relative to the underlying liquidity. Crowdedness can be quantified by assessing the total value of institutional positioning in an asset in relation to its trading volume. These trades often command an excess premium due to the additional risk assumed; however, the risk is asymmetrically skewed to the downside. The increasing concentration within global markets—particularly in the U.S. technology sector—is well-documented. Yet, a deeper examination reveals an even more striking picture when analyzing the underlying market dynamics. Capital flows are critical, and following these movements unveils a compelling narrative.
Over the past several years, significant turnover has occurred beneath the surface. Active mutual funds have been experiencing sustained asset outflows, while exchange-traded funds (ETFs)—predominantly market-cap-weighted index funds—have absorbed the majority of these assets. In absolute dollar terms, the bulk of capital has been allocated to the US passive large-cap blend segment. Structurally, active managers tend to be underweight the largest market-cap names relative to passive market-cap-weighted index funds such as SPY and VOO, two of the largest passive ETF’s which give exposure to the S&P 500. Instead, they generally allocate a greater proportion of capital to smaller, undervalued, or underweighted stocks compared to these benchmark products.
While ETFs are truly the next best thing since sliced bread—offering tax efficiency, transparency, lower costs, and trading flexibility— although I must admit some bias, given my primary professional focus on ETFs. However, that is not the subject of this discussion. According to Morningstar, passive ETFs, which are predominantly market-cap-weighted, saw inflows exceeding $800 billion in 2024 and $400 billion in 2023. Meanwhile, active ETFs attracted over $200 billion in 2024 and $100 billion in 2023. Amid these shifts, ‘open ended’ active fund managers have been net sellers of their overweight positions in smaller and underweighted market cap index stocks; reallocating capital toward large-cap blend index funds. These passive funds, by design, assign greater weight to the largest companies by market capitalization. As a result, for every $100 invested into passive index funds, approximately $35 is allocated to the top 10 stocks, while the remaining $65 is distributed across the other 493 stocks in the index.
Depending on one's perspective on market efficiency, the previously mentioned trends may be perceived as either a cause for concern or an opportunity. Investors who believe markets are inefficient may recognize potential mispricing and areas for alpha generation. Market-cap-weighted equity index funds, which have absorbed the majority of capital flows, inherently increase their exposure to stocks that have appreciated in price while reducing exposure to those that have declined. This structural mechanism often results in an overweighting of overvalued stocks and an underweighting of undervalued stocks, thereby amplifying concentration risk. Another key inefficiency arises from the tendency of markets to front-run stocks before their inclusion in major market-cap-weighted indices. This creates an additional layer of inefficiency for investors, as they often end up holding portfolios that are overweight stocks that have already appreciated significantly, incorporating a front-running premium, while underweighting stocks that have depreciated and may be undervalued relative to their economic fundamentals. Regardless of one's stance on market efficiency, U.S. market-cap-weighted equity index products—the dominant allocation in most investor portfolios—are currently a crowded trade. Today, the aggregate exposure to the Magnificent 7 stocks stands at approximately 31.3%, meaning nearly one-third of the market capitalization is concentrated in these seven companies. However, on a beta-adjusted basis, the exposure rises to 44.7%, meaning an investor holding a market-weighted portfolio effectively has nearly half of their fund’s beta-adjusted exposure concentrated in just these seven stocks. This remains near the highest levels observed in the last 25 years.
(Source: Trivariate Research, LP)
Narrow market leadership skews index constituent weightings toward a smaller subset of companies, effectively reducing diversification. As market concentration increases, exposure to a limited number of cyclical companies heightens systemic vulnerability, making the broader market more susceptible to idiosyncratic, company-specific risks. Currently, both U.S. and international investors are heavily allocated toward the largest seven stocks, as illustrated in the chart below. This concentration has led to reduced liquidity in these mega-cap stocks within major indices like the S&P 500, largely due to the significant ownership by passive, market-cap-weighted strategies. Mechanically, this phenomenon aligns with the structural differences between active and passive management. Active managers typically maintain an underweight position in the largest market-cap names and engage in price discovery through active trading. In contrast, passive funds allocate capital based on market weight, indiscriminately purchasing the largest stocks at prevailing prices—regardless of valuation.
(Source: Morten Springborg, Worldwide Asset Management, as of December 2024)
While this information may seem daunting, the wise words of Warren Buffett come to mind: “The true investor welcomes volatility.” A seminal study by Werner F. M. De Bondt and Richard Thaler, titled “Does the Stock Market Overreact?”, explores the phenomenon of overreaction in financial markets. Their research analyzes stock performance over a three-year period following extreme price movements. Key findings indicate that investors tend to overreact to recent information, causing stocks that have significantly outperformed or underperformed to deviate from their intrinsic value. Over time, these mispricings correct, often leading to price reversals, with loser portfolios outperforming winner portfolios in subsequent years. While the concept of the wisdom of the crowd is widely accepted, Cliff Asness presents a compelling counterargument in his research piece, “The Less-Efficient Market Hypothesis.” He poses a critical question: “What if the crowd isn’t independent, but acts in unison?” If market participants increasingly herd around the same information and narratives, the once-efficient crowd dynamics could lead to inefficiencies rather than reduce them. This concern is particularly relevant in today’s information-driven age, where access to real-time data may encourage synchronized behavior rather than independent decision-making.
The rise of passive investing creates significant opportunities for active managers and allocators, as market inefficiencies become exacerbated by indiscriminate flows. Individual stock movements are increasingly dictated by basket trades and thematic exposures rather than fundamental valuations. To navigate this environment effectively, investors should consider diversification strategies that go beyond traditional market-cap-weighted approaches. This includes: Diversifying Manager Selection: Incorporating active managers and alternative weighting strategies to mitigate the risks associated with passive concentration. Expanding Asset Allocation: Allocating capital to liquid alternatives, real assets, and international equities to enhance portfolio resilience and capture opportunities across different market conditions. By embracing thoughtful diversification, investors can position themselves to capitalize on potential mispricings and turn market volatility into a strategic advantage.
For more news, information, and analysis, visit the ETF Strategist Channel.
Sources:
https://jeffreyptak.substack.com/p/us-stocks-crushed-over-the-past-decade
https://www.morningstar.com/funds/where-etf-investors-put-their-money-2024
Does the Stock Market Overreact by. Werner F. M. De Bondt and Richard Thaler
https://www.jstor.org/stable/2327804
The Less-Efficient Market Hypothesis by Cliff Asness
https://www.aqr.com/Insights/Perspectives/The-Less-Efficient-Market-Hypothesis
https://www.cworldwide.com/media/v1pbt4cb/from-diversification-to-distortion-the-impact-of-passive-investment-flows.pdf
The views expressed herein are exclusively those of Orion Portfolio Solutions, LLC d/b/a Brinker Capital Investments, a registered Investment Advisor, and are not meant as investment advice and are subject to change. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.
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