In his paper “Passive Investing and the Rise of Mega-Firms,” joint with Hao Jiang and Lu Zheng and forthcoming in the Review of Financial Studies, Dimitri Vayanos examines one of the most transformative developments in modern finance: the rise of index-based investing and its implications for market efficiency. As index funds and ETFs grow to dominate global markets, Vayanos and his co-authors develop a theoretical framework that explains how index investing shapes asset prices, alters risk premia, and influences welfare across the financial system.
Vayanos revisited two cornerstone theories. The first, based on Grossman and Stiglitz (1980), posits that fewer active, informed investors make prices less reflective of fundamentals. The second, inspired by Harris, Gurel, and Shleifer, emphasizes the index effect — where stocks added to indices see temporary price boosts. However, Vayanos advanced a distinctive view: even when indices encompass all stocks, index investing still “generates a systematic bias for mega firms, the largest stocks in the economy.” In his model, the structural mechanics of passive flows lead large-cap equities to experience disproportionate price rises, lowering their cost of capital and increasing their dominance.
Through a continuous-time framework, Vayanos showed that passive inflows cause asymmetric valuation effects. As investors shift from active to passive strategies, firms favored by “noise traders,” and hence underweighted by “smart-money” strategies, experience an increase in demand. Demand has a small price effect on small firms because their idiosyncratic (i.e., firm-specific) risk is negligible, but a large effect on the mega-caps. This produces a feedback loop. As the mega-caps rise in price, occupying a larger share of the index, investors underweighting them relative to the index reduce their positions to keep their tracking error from rising. This generates more demand for the mega-caps, causing their prices to rise further. Over time, the market becomes tilted toward the largest firms, while smaller stocks see relatively muted or even negative effects.
Empirical tests lent weight to the theory. Analyzing quarterly flows into S&P 500 ETFs and mutual funds between 1996 and 2020, Vayanos and his co-authors found that increases in passive flows were closely associated with stronger performance among the top 10 and 50 firms within the index. Conversely, similar analysis of the S&P 600—which tracks smaller companies—revealed no such pattern, underscoring that the phenomenon is unique to large, market-dominant stocks. Furthermore, passive inflows predict higher idiosyncratic volatility among large firms, consistent with the feedback loop.
Vayanos emphasized that passive investing, though often viewed as a neutral or efficient strategy, is actively reshaping market structure and valuation dynamics. By favoring the largest firms and raising aggregate market levels, passive flows create systemic imbalances that challenge traditional notions of market efficiency. As he cautioned, “doing nothing effectively is doing something” — a reminder that even strategies built on neutrality can have profound and far-reaching effects on financial markets.
View the full research via: Autumn 2025, Utrecht, The Netherlands • Inquire Europe