Passive investing can be seen as a disruptive innovation that has also reduced costs for active investors. It has made active investors more engaged, aligning their compensation more closely with their added value. Meanwhile, passive investors benefit as free riders from the extensive work undertaken by active investors.
This does not refer to a single active investor or a specific group of investors but rather the collective of active investors. The power of this process is comparable to Adam Smith’s invisible hand of the market. Each active investor pursues their own self-interest, yet collectively, they contribute to greater overall prosperity.
The invisible hand of the market ensures optimal allocation. A well-known example is asking a group of people to estimate the number of marbles in a jar. As the group size increases, the likelihood that the average estimate is close to the actual number also rises. An individual may guess the correct number once, but it is nearly impossible for the same person to be consistently accurate. Meanwhile, the collective, when the experiment is repeated, repeatedly arrives at a result near the correct answer. The wisdom of the crowd surpasses that of the individual—counterintuitive, but true.
This collective wisdom can also be harnessed to predict the future. Financial markets are often the best forecasters of what lies ahead. However, this requires diversity of opinion. If everyone invests in an index, this process is disrupted, though determining the exact tipping point is difficult. In theory, the market becomes smarter as more people invest in indices, but it could also become less efficient if everyone does so.
A key consequence is that markets with fewer active investors become more susceptible to narratives. A narrative is the ability of humans to construct stories, which fundamentally differentiates us from other species. Narratives, whether in the form of religion or ideology, enable large-scale cooperation.
In a completely free market, there is a perfect balance between supply and demand, even if it does not always appear that way. The collective’s ability to forecast the future ensures that even bubbles ultimately yield the desired outcome. Take the dot-com bubble, often cited as an example of irrational exuberance. Such a bubble is the only way to accelerate the implementation of new technology. Just as the tulip mania ensured that the Netherlands remains a major tulip producer, the dot-com bubble led to widespread access to fast (mobile) internet at a relatively low and often fixed cost. In a bubble, the free market ensures that capital is allocated to the right solutions.
For a free market to function effectively, participants must hold diverse opinions. However, this is easier said than done, as herd behaviour is deeply ingrained in human nature. There is safety in numbers. It feels much safer to conform to behaviour that appears rational rather than devising a unique, rational strategy—especially when time is limited. Children instinctively imitate their parents.
People act based on what others perceive as the correct behaviour. Communication of these perceptions occurs through narratives. A narrative is not just a single message but a series of messages related to events, situations, or developments. If everyone drives on the right side of the road, it is beneficial to do the same, without questioning whether driving on the left might be better.
A downside of the invisible hand is that producers may collude to gain a relative power advantage over consumers, disrupting the free market and distorting optimal pricing. However, this should not be confused with criticism of capitalism itself.
Criticism of the free market, and by extension capitalism, is misguided when directed at market mechanisms but valid when addressing collusion. Additionally, critics of the free market often call for government intervention. Yet, while free markets excel in selecting the right solutions, communism has demonstrated that governments are particularly adept at choosing the wrong ones.
Interestingly, index investors do not make full use of the free market either, as they also make subjective choices. What assets should be included in an index? Should an equity investor also allocate to private equity? The differences in returns among index investors are sometimes even greater than those among active investors. This is partly due to the ease with which investors choose a particular index. Passive investors tend to accept the first available index as the correct one, while active investors exhibit enough diversity for market forces to influence final outcomes.
The question remains whether active investors today are smarter or less effective than in the past. That is difficult to answer. However, what is clear is that active investors increasingly incorporate narratives into their investment strategies. This is why thematic investing has become so effective. The narrative surrounding artificial intelligence has driven the strong performance of the Magnificent Seven.
Recently, DeepSeek has begun shifting this narrative, further fuelled by the threat of tariffs and the waning dominance of the United States. Investors are now less surprised by China’s outperformance. DeepSeek’s competition is also expanding the future application of artificial intelligence, albeit at a lower price—another win for the free market.
Han Dieperink is chief investment officer at Auréus Vermogensbeheer. He previously served as chief investment officer at Rabobank and Schretlen & Co.