Passive investing is no longer diversified. The S&P 500 is now over 50% weighted towards AI and big tech, with the top five companies alone comprising 30% of the index. Many investors unknowingly double down on this risk by holding an index fund while also buying the same stocks individually.

A market-cap weighted index like the S&P 500 is, by its very structure, a momentum strategy. As a stock's price rises, its market cap increases, automatically boosting its weighting in the index. This forces passive investors to allocate more capital to outperforming stocks, a core tenet of momentum investing.

The S&P 500 is no longer a passive, diversified market index. Its market-cap weighting has created a concentrated, active-like bet on a few dominant tech companies. This concentration is the primary reason it consistently beats most diversified active managers, flipping the script on the passive vs. active debate.

The success of market-cap weighted indexes stems from a core trend-following principle: a few outlier stocks generate nearly all gains. The index's mechanism of increasing a stock's weight as its price rises and decreasing it as it falls mimics a basic, passive trend strategy.

Market-cap-weighted indexes create a perverse momentum loop. As a stock's price rises, its weight in the index increases, forcing new passive capital to buy more of it at inflated prices. This mechanism is the structural opposite of a value-oriented 'buy low, sell high' discipline.

By design, market capitalization-weighted indices increase allocations to assets as their prices rise. This forces investors to continuously buy more of what has already performed well, leading to concentration in popular, often expensive, assets and sectors from the previous market cycle.

Terry Smith contends that passive investing is mislabeled. It's a momentum strategy that forces capital into the largest companies regardless of valuation. With over 50% of AUM in passive funds (up from <10% in 2000), this creates a powerful feedback loop that distorts markets more than the dot-com bubble ever did.

Market-cap weighting turned the S&P 500 into a momentum fund for megacaps, leading to a decade of outperformance versus its equal-weight counterpart—a historical anomaly. Recent signs of equal-weight taking the lead suggest a potential market regime shift back towards value and smaller companies.

So-called passive indexes have a small but impactful "active side" in their turnover. This component behaves like a flawed momentum strategy, forcing the index to systematically buy stocks after they've surged and sell them after they've plummeted, creating a performance drag.