At a potential valuation approaching $2 trillion, SpaceX would immediately become one of the largest companies in the world. Its eventual inclusion in major indices could trigger billions of dollars of automatic buying from passive funds. Many investors see this as a bullish catalyst. But perhaps the more interesting question is what it reveals about the way markets now allocate capital.

The Great Passive Experiment

To understand why SpaceX matters, it is worth understanding how unusual today's market structure has become.

The first index fund was launched by John Bogle at Vanguard in 1976. At the time, the idea was ridiculed. Critics argued that investors would never be satisfied with simply matching the market rather than attempting to beat it. For many years, passive investing remained a niche strategy.

Even as late as the early 1990s, actively managed funds dominated the investment landscape. Most capital was allocated by fund managers making explicit judgements about valuation, earnings prospects and economic conditions.

The balance began to shift during the 1990s and accelerated dramatically after the turn of the century. The bursting of the technology bubble in 2000 exposed the difficulty many active managers faced in consistently outperforming benchmarks. The Global Financial Crisis of 2008 further undermined confidence in active management.

Meanwhile, the rise of exchange-traded funds made passive investing cheaper, simpler and more accessible than ever before. The result was one of the largest reallocations of capital in financial history. Over the past two decades, trillions of dollars have migrated from active strategies into passive funds tracking indices such as the S&P 500, Nasdaq 100 and MSCI World.

Today, passive funds account for roughly half of all US mutual fund and ETF assets, and their influence continues to grow. Yet there is an important caveat. The modern passive era has largely coincided with one of the most powerful bull markets in history. Since the aftermath of the Global Financial Crisis, investors have experienced an extraordinary period of rising asset prices. There have been corrections, including the pandemic sell-off of 2020 and the inflation-driven decline of 2022, but neither developed into the kind of prolonged bear market that defined previous eras.

The 1970s endured a decade of inflation and stagnation. The period between 2000 and 2013 delivered little real return for many broad equity investors. The Great Depression saw US equities lose almost 90% of their value. The majority of assets currently invested in passive strategies have never experienced a prolonged period of sustained outflows combined with a deep and extended bear market. That does not mean passive investing will fail. But it does mean many of the assumptions underpinning its success have been formed during an unusually favourable environment. The great passive experiment has been remarkably successful.

The question is whether we have seen the entire experiment, or merely the favourable half of it.

Passive Investing Is Not Truly Passive

The success of passive investing has been one of the defining financial stories of the past two decades. Yet passive investing contains a contradiction that few investors acknowledge. Passive investing is only passive from the perspective of the individual investor. At the market level, it is an extraordinarily active force.

Every pound invested into an index fund is allocated according to a series of decisions made by index providers. Someone decides which companies belong in the index. Someone decides how they are weighted. Someone decides when constituents are added or removed. Trillions of dollars then follow those decisions automatically.

Traditional investors attempt to allocate capital based on their assessment of value. They analyse businesses, estimate future cash flows and decide whether a share price offers an attractive return. Passive funds do none of these things. They buy because a company is in an index and because its market capitalisation dictates its weight. In theory, active investors continue to set prices while passive investors merely accept them. In practice, the extraordinary growth of passive investing may have created a more complicated reality.

The Self-Fulfilling Cycle

The success of passive investing may itself have become partially self-fulfilling. As money flows into index funds, the largest constituents receive the largest inflows. Those inflows support valuations. Higher valuations increase index weights. Higher weights attract larger passive allocations. Success attracts capital, which reinforces success. The process is not unlike momentum investing, except that the buying is automatic.

This is not to suggest that the largest companies have not deserved their success. Apple, Microsoft and Nvidia have all produced exceptional business results. The question is whether passive flows have amplified those outcomes.

Over the past decade, investors have increasingly allocated capital to the companies that have already become the largest. The result has been an unprecedented concentration of capital in a small number of firms that now dominate major indices.

SpaceX may soon become the clearest example of this phenomenon.

SpaceX as the Ultimate Test Case

SpaceX enters public markets with almost every characteristic required to maximise this effect. The company is globally recognised. It operates in industries associated with innovation, technology and national importance. Retail investors have spent years waiting for access. Institutional investors are eager for exposure. Most importantly, it may enter public markets at a valuation that immediately places it among the largest companies in the world.

The business could be cheap or expensive (perhaps wildly over valued) but the outcome is the same. The shares must be purchased and the decision will not be based on analysis, it will be simply based on inclusion.

Every Buy Requires a Sell

The popular narrative surrounding SpaceX is that passive inclusion will create enormous buying pressure. This is true. What is discussed less often is where that money comes from. Passive funds cannot create capital. To buy SpaceX they must sell something else. Every pound directed into SpaceX represents a pound withdrawn from an existing constituent.

Suppose SpaceX enters an index at a substantial weighting. Existing companies, many of them profitable, mature businesses generating significant cash flow, will be partially sold to fund the purchase. The decision has nothing to do with comparative attractiveness. It is not the result of a judgement that SpaceX offers better risk-adjusted returns than the companies being sold. It is simply a consequence of index methodology. Capital is reallocated because one company became larger. Not because it became better.

Passive Is Momentum by Another Name

This is why passive investing is not as neutral as it appears. A market-cap weighted index is, by design, a form of momentum allocation. It allocates more capital to companies whose share prices have already risen and less capital to those whose share prices have fallen. The index does not ask whether the rising company is now expensive. It does not ask whether the falling company is now cheap. It simply follows the price. This creates a structural bias towards yesterday's winners. The winners become larger. Because they are larger, passive funds must own more of them. Because passive funds must own more of them, future inflows are directed disproportionately towards them. The mechanism may be rules-based, but the effect is not neutral. It rewards size, momentum and index inclusion. It does not reward valuation.

The Power of Index Providers

There is another uncomfortable reality that sits beneath the surface of passive investing. It is often presented as democratic, decentralised and market-led, with millions of individual investors collectively allocating capital through low-cost funds that simply track the market, thereby removing the influence of active managers and reducing the impact of individual investment decisions. Yet the reality is considerably more complex.

The more capital that flows into passive strategies, the more influence is concentrated in the hands of those responsible for constructing the indices themselves. Index providers determine which companies qualify for inclusion, when they are admitted, when they are removed, how they are classified, and what liquidity, profitability, governance and listing requirements must be satisfied before they can gain access to these vast pools of capital. These decisions may appear technical and administrative in nature, but their consequences can be profound. Inclusion in a major index can unlock billions of pounds of automatic demand as passive funds purchase shares regardless of valuation, while exclusion can leave a company largely ignored by the very same capital. In effect, index inclusion has become a gateway to investment flows, meaning that a relatively small number of organisations now exercise considerable influence over the direction of trillions of pounds of capital.

This raises an important question about the true nature of passive investing. Investors often believe they are simply buying "the market", but markets are not natural phenomena; they are constructed according to rules, methodologies and judgements established by index providers. The S&P 500, for example, is not merely a list of the 500 largest companies in America but a curated index governed by eligibility criteria and overseen by a committee that ultimately decides which companies belong and which do not. The same principle applies across much of the passive investment universe. The irony is that while passive investing has reduced the influence of traditional active fund managers, it has simultaneously increased the importance of index providers whose decisions increasingly shape the flow of capital across global markets. Investors have not eliminated active decision-making from the investment process; they have simply delegated it. The investor may be passive, but the index committee is not, and as passive investing continues to grow, the significance of those decisions may become one of the most important and least discussed forces influencing modern capital markets.

What Happens When the Tide Turns?

Yet perhaps the most important question is not what happens when money flows in. It is what happens when money flows out. The rise of passive investing has coincided with one of the longest and most powerful bull markets in financial history. For much of that period, investors have experienced a relatively simple dynamic: fresh capital enters index funds and is allocated according to market capitalisation. The largest companies receive the largest inflows. But markets do not move in one direction forever. What happens when the tide turns?

If passive investing acts as a form of automatic momentum on the way up, it may also act as a form of automatic momentum on the way down. A company whose weight increases because its share price rises receives more capital. But a company whose share price falls sees its index weight reduced. Lower weights attract less capital. Further weakness reduces weights again. The same mechanism that reinforces success can also reinforce decline. The assumption is often that passive funds simply follow the market.

But when passive investing becomes sufficiently large, there is a legitimate question as to whether it begins to amplify market movements rather than merely reflect them. For now, the system has largely operated in a world of inflows. The real test comes during outflows. SpaceX may ultimately justify any valuation the market assigns to it. That is not the point.

The point is that modern markets increasingly allocate capital according to size, inclusion and momentum rather than valuation alone. If SpaceX enters public markets at a trillion-dollar valuation and immediately attracts billions of dollars of automatic buying, investors should ask themselves a simple question. Are passive funds discovering value? Or are they merely reinforcing price?

Because if the answer is the latter, then the forces that propel companies higher during the good times may be the very same forces that accelerate declines when sentiment changes.  And that may be the greatest contradiction of passive investing of all.

What Does This Mean for Investors?

None of this should be interpreted as a prediction that passive investing is about to fail or that SpaceX will prove to be a poor investment. Markets have always evolved and new forms of capital allocation have emerged throughout history. Passive investing has delivered substantial benefits to investors through lower costs, broad diversification and strong long-term returns. Nor are we suggesting that a reversal in passive flows is imminent.

However, we do believe that the increasing concentration of capital in a relatively small number of companies, combined with the growing influence of index construction and momentum-driven allocation, creates risks that many investors may underestimate. The SpaceX IPO simply provides a useful lens through which to examine those risks.

Periods of market enthusiasm surrounding landmark IPOs are nothing new. History suggests they are often accompanied by elevated volatility, strong investor sentiment and significant price swings as markets attempt to determine fair value. We would expect SpaceX to be no different.

While our portfolios are not immune to broader market movements, they are constructed with diversification, valuation discipline and risk management at their core. Rather than relying on the fortunes of a small number of index heavyweights, we seek exposure across a broad range of asset classes, sectors and investment opportunities.

If periods of volatility do emerge, whether driven by the SpaceX, Anthropic or OpenAI IPOs, shifts in passive fund flows or wider market conditions, our expectation is not that portfolios will avoid all short-term fluctuations. That would be unrealistic. Instead, our objective is to build portfolios that remain resilient across a range of market environments, including those that may look very different from the conditions that have supported the rise of passive investing over the past two decades. The real test of any investment strategy is not how it performs when capital is flowing in and markets are rising. It is how it behaves when conditions become more challenging.

That is a test the entire investment industry may face in the years ahead.