What market concentration means for active and passive management

Introduction

Developments in artificial intelligence (AI) and the performance of big tech shares have heightened global investor concerns about equity market concentration. This issue is most pronounced in the US where the top 10 shares in the S&P 500 Index - led by technology giants including Nvidia, Apple, and Microsoft – account for 136.5% of the index by market capitalisation. Equitymarket concentration is also near a record high in emerging markets.

Market concentration is a subject that appears simple until you try to think about it carefully. At first glance, the story seems obvious: a small number of very large companies account for an unusually large share of index returns, which creates problems for active managers that do not own enough of them. Meanwhile, passive managers appear to benefit automatically because they own the market-cap index by construction. That is a standard narrative. It is not wrong, but it is not complete.

In this article we briefly discuss some of the deeper issues. Index concentration is a pressing concern for investors around the world and is not merely a problem of index construction or relative performance. It also changes the opportunity set, the risk structure, the meaning of diversification, and the practical behaviour of both active and passive investment management.

Concentration vs overvaluation

The first point is to distinguish concentration from overvaluation. The two are often discussed together, but they are not the same thing. A market can be highly concentrated because a few companies have genuinely superior economics: higher margins, better balance sheets, stronger network effects, more durable reinvestment opportunities, and more scalable business models. In that case, concentration may be the market’s way of reflecting a real economic phenomenon.

Conversely, concentration can also arise from extrapolation, narrative dominance, liquidity preference, or a self-reinforcing flow of capital to the winners. The difficulty is that, in real time, these explanations are not mutually exclusive. The leading companies may be both exceptional businesses and expensively valued. That ambiguity is precisely why the issue isintellectually interesting.

The passive angle

For passive managers market concentration is often presented as a free lunch. If the largest companies dominate returns, then the passive investor owns them in proportion to their size and participates fully in the trend. There is no career risk from being underweight the winners, no need to explain why one does not own the dominant shares, and no requirement to decide whether the market has become irrational. Passive management simply accepts the market’s collective judgement. In a concentrated bull market, this can be extremely powerful.

But passive investing does not escape concentration risk. It merely absorbs it without an explicit decision. A market-cap index is not a neutral portfolio in the sense that it is evenly balanced across economic exposures. It is neutral only relative to the market’s current capitalisation structure. If the market becomes dominated by a narrow set of companies, sectors, factors, currencies, or business models, passive investors become increasingly exposed to those same risks. This may be entirely rational but it should not be mistaken for broad diversification.

This is where the language of ‘owning the market’ can become misleading. In theory, owning the market sounds diversified. In practice, the investable market can itself become concentrated around a few engines of return. The passive investor may still hold hundreds or thousands of shares, but the marginal outcome may be determined by a small number of mega-cap companies. The portfolio looks diversified by number of holdings but is less diversified by contribution to risk and return. The distinction matters.

The deeper issue for passive managers is that they outsource not only security selection but also the discipline of valuation-weighted capital allocation. As companies rise in price and market value, passive investors buy more of them automatically or at least hold more of them as their index weight increases. This is not necessarily irrational. Market-cap weighting has many virtues: low turnover, low cost, high capacity, and no need for subjective judgement. But it also embeds momentum. It allocates more capital to what has already become large, regardless of whether the increase in market value was driven byfundamentals, sentiment, or both.

This does not mean passive investing is flawed. It means passive investing is honest about what it is: participation in the market portfolio, with no protection from the market’s internal imbalances.

Passive investors should therefore be careful not to confuse low active risk with low absolute risk. A passive global equity portfolio may have little risk of underperforming the index, but it can still have substantial exposure to a narrow cluster of companies whose valuations depend on demanding assumptions about future growth, profitability, regulation, technology, and competitive advantage.

The active angle

For active managers, concentration creates a different set of challenges. The most obvious is benchmark pressure. If a few shares dominate index returns, an active manager who is underweight those shares will struggle, even if the rest of the portfolio performs well. This can make skill difficult to observe. A manager may have selected many good shares, avoided many poor shares but still underperformed because of one or two large underweights. Conversely, a manager may appear skilful largely because they held the dominant index names.

This is particularly important for benchmark-aware active managers. If a single share has a 7% or 8% index weight, then a portfolio weight of 4% may look like a large position in absolute terms but is a significant underweight. The manager may like the company, but not enough to match the index. If the share continues to rise, the underweight hurts. This creates a strange world in which owning a company is not enough; one must own enough of it relative to the benchmark. In highly concentrated markets, active management becomes less about what one owns and more about the size of active positions in a few dominant names.

Behavioural consequences
Managers that are judged over short periods may feel forced to hold large benchmark weights in the dominant shares, not necessarily because their conviction is highest there, but because the career risk of being meaningfully underweight is too great. The result is a form of closet indexing at the top of the market. The active manager’s portfolio may still contain interesting smaller positions, but the real benchmark-relative outcome is governed by whether the manager is close enough to the mega-cap weights.

This creates a paradox
As markets become more concentrated, the need for genuine active judgement arguably increases, because the index itself becomes more dependent on a narrow set of assumptions. Yet the ability of active managers to express differentiated judgement may decrease, because the performance penalty for being early, wrong, or simply different, becomes more severe. Concentration therefore narrows not only the market’s return drivers, but also the behavioural freedom of benchmarksensitive active managers.

It would be too simplistic to simply say that concentration is bad for active management. It may be bad for conventional benchmark-relative active management, especially over shorter horizons, but it can also create opportunities.

Broader opportunity set
If capital is increasingly drawn into the largest index constituents, securities outside the dominant group may become neglected. Smaller companies, unfashionable sectors, non-US markets, value-oriented businesses, and companies with more cyclical or idiosyncratic earnings may be priced with less enthusiasm. That does not guarantee future outperformance but it can improve the opportunity set for patient active investors.

The difficulty is that these opportunities may be latent for a long time. Cheap assets can remain cheap. Neglected companies can remain neglected. A manager that is fundamentally right may still be commercially wrong if clients do not have the patience to endure the period before the market recognises the value. This is one of the central tensions in active management - investment skill requires differentiation, but business survival often requires not being too differentiated for too long.

Risk - stock-specific risk vs benchmark-relative risk
Concentration also affects how we interpret diversification. A traditional active manager may appear diversified because the portfolio holds 40 to 80 stocks across sectors. But if the portfolio has a large underweight to the dominant index names, its active risk may be highly concentrated. The manager may have diversified stock-specific risk but concentrated benchmark-relative risk. Meanwhile, the passive index may appear diversified by benchmark standards but concentrated in economic exposure. Neither portfolio is automatically diversified in the deeper sense. One must ask: diversified relative to what risk?

The DFM / Multi-manager angle

This matters especially for asset allocators and multi-managers. The question is not simply whether active or passive is better. The question is what role each component plays in the total portfolio. Passive exposure may provide efficient, low-cost participation in the broad market, but in a concentrated environment it also imports the market’s concentration. Active managers may provide differentiated exposures, but only if they are genuinely different and if the investor has the governance discipline to tolerate periods of underperformance. Combining multiple active managers does not necessarily solve theproblem if all of them are benchmark-aware and all of them feel compelled to own the same dominant names.

Alpha dilemma
One of the more subtle effects of concentration is that it changes the meaning of alpha. In a broad market alpha may come from many sources: stock selection, sector allocation, factor tilts, quality assessment, valuation discipline, or behavioural arbitrage. In a concentrated market reported alpha can become heavily contaminated by a small number of mega-cap decisions. Did the manager generate alpha, or did they simply own Nvidia, Apple, Microsoft, or the equivalent dominant names at the right time? Did they understand the economics better than the market or did they benefit from the same momentum that lifted the index? These are not cynical questions; they are necessary ones.

Similarly, underperformance in a concentrated market may not automatically indicate poor skill. A manager may underperform because their investment philosophy does not allow them to hold extreme weights in expensive securities. That may be a weakness if the philosophy is too rigid. But it may also be the very discipline one wants when the cycle eventually turns. The challenge is separating principled underperformance from stubbornness; and valuation discipline from value traps. That distinction cannot be made by looking at performance numbers alone.

Market concentration raises questions about systemic risk
When a small group of companies drives index returns, the market becomes more vulnerable to common shares affecting those companies. These shocks need not be purely financial. They may involve regulation, taxation, geopolitical constraints, supply chains, technological disruption, antitrust action, energy availability, semiconductor capacity, data privacy, or shifts in the economics of artificial intelligence. The more the market valuation depends on a narrow group of companies continuing to deliver extraordinary outcomes, the more fragile the aggregate index becomes to disappointment in those outcomes.

Yet one should also resist lazy comparisons with past bubbles — not every dominant company is destined to mean revert into mediocrity. Some companies become large because they are genuinely better businesses. The modern economy has features that can support persistent concentration: intangible assets, platform economics, network effects, winner-takes-most dynamics, global scale, and high incremental margins. A simplistic ‘this must reverse because it has gone too far’ argument is not sufficient. Mean reversion is powerful, but it is not a law that operates on a convenient schedule.

In conclusion

The right conclusion, therefore, is not that passive investors are complacent and active managers are wise. Nor is it that active managers are obsolete and passive investors are rational. The more useful conclusion is that concentration forces both sides to become more honest.

Passive investors must recognise that they are not avoiding an active view. They are accepting the market’s view - including its concentration, its valuation structure and its embedded assumptions about the future. That may be perfectly sensible, especially after costs. But it should be understood as a choice.

Active managers must recognise that avoiding the dominant names is not, by itself, a virtue. Being different is not the same as being right. A thoughtful active manager needs a clear view on whether the largest companies are over-owned, overvalued, misunderstood, or simply excellent businesses that deserve their weight. They also need to be explicit about whether they are trying to beat the benchmark over one year, a full cycle, or a much longer horizon. Without that clarity, the debate becomes confused.

For asset allocators, the central task is to decide which risks are being deliberately owned and which are being accidentally inherited. Market concentration is not automatically good or bad. It is a fact about the structure of current opportunity and risk. It may reflect genuine economic superiority, speculative excess, or some combination of the two. The response should not be ideological, it should be analytical.

In practical terms, this means looking through portfolios to understand true exposure to the dominant shares and themes. It means distinguishing between the number of holdings and sources of risk. It means evaluating active managers not only by recent relative performance, but by whether their philosophy is coherent in the face of concentration. It means accepting that passive exposure may be efficient but not neutral in an absolute sense. And it means recognising that the best opportunities for active management may arise precisely when it is most uncomfortable to be active. In the end, market concentration is a mirror. It reflects the market’s current beliefs about where economic value resides. Passive managers accept that reflection. Active managers question it, refine it, or selectively reject it. Neither stance is inherently superior. The real issue is whether the investor understands the stance being taken, the risks that come with it, and the conditions under which it may fail. That understanding matters far more than the label ‘active’ or ‘passive.