The Hidden Costs of Passive Investing: How Conflicts of Interest Erode Long-Term Returns

Passive investing has long been celebrated for its low fees and simplicity. Yet beneath the surface, a web of conflicts of interest threatens to undermine its promise. From opaque fee structures to market concentration risks, these issues create a quiet drag on investor returns—one that regulators and investors must confront head-on.

The Fee Structures That Hide in Plain Sight

Passive fund managers often rely on indirect revenue streams that prioritize their own interests over those of investors. For example, 12b-1 fees—annual charges for marketing and distribution—are embedded in expense ratios, masking their true cost. While management fees have declined, distribution fees have risen to offset these losses, eroding investor returns over time [2]. Similarly, revenue-sharing arrangements allow fund managers to receive payments from wealth firms that recommend their products, incentivizing the sale of higher-cost options [5]. These practices create a misalignment between fund managers and investors, where the former benefit from complexity while the latter bear the cost.

A 2025 study by Jiang, Vayanos, and Zheng underscores this dynamic: passive flows disproportionately inflate the stock prices of large firms, especially those already overvalued. This feedback loop amplifies volatility and reduces diversification benefits, leaving investors exposed to systemic risks [1].

The Illusion of Cost Efficiency

While index funds and ETFs have gained popularity for their low expense ratios, the cost floor is not as low as it seems. By 2024, 51% of long-term fund assets were in index products, yet many funds began raising fees discreetly to offset declining revenues [1]. This trend suggests that the era of ever-declining costs may be ending.

Moreover, the rise of open architecture platforms has introduced new conflicts. Some OCIOs (outsourced chief investment officers) receive payments from underlying managers or promote proprietary products, leading to suboptimal investment decisions [4]. These practices obscure the true cost of investing, making it harder for investors to assess performance.

Market Concentration and Volatility: A Systemic Risk

The dominance of passive investing has reshaped financial markets. Large firms now dominate indices, and passive funds mechanically follow these benchmarks, amplifying price movements. A 2024 analysis by Lu Zheng found that this value-weighted approach biases the market toward overvaluation of mega-firms, increasing their idiosyncratic volatility [2]. Active investors, deterred by this volatility, are less likely to correct mispricings, allowing distortions to persist [1].

This concentration also reduces diversification benefits. Stocks become more correlated, meaning a downturn in one sector can ripple across the market. The 2025 study by Jiang et al. warns that such dynamics could destabilize financial systems, particularly during periods of economic stress [1].

Regulatory Risks and the Path Forward

Regulators have taken steps to address these issues, such as the SEC’s 2020 crackdown on fund disclosures. However, enforcement remains inconsistent. Investors must demand transparency in fee structures and scrutinize the alignment of incentives between fund managers and clients.

For investors, the lesson is clear: passive investing is not a free lunch. While it offers cost efficiency, its hidden conflicts and market risks require careful management. Diversifying across active and passive strategies, combined with rigorous due diligence, may offer a more balanced approach.

Source:

[1] Study supports what many suspected about passive investing [https://www.firstlinks.com.au/study-supports-what-many-suspected-about-passive-investing]
[2] Competition among mutual funds [https://www.sciencedirect.com/science/article/abs/pii/S0304405X10001881]
[3] The implications of passive investing for securities markets [https://www.bis.org/publ/qtrpdf/r_qt1803j.htm]
[4] OCIO Conflicts of Interest: Fee Fiddles and Performance Puffery [https://www.alpha-week.com/ocio-conflicts-interest-fee-fiddles-and-performance-puffery]
[5] How fund managers do revenue sharing with wealth firms [https://www.financial-planning.com/news/how-fund-managers-do-revenue-sharing-with-wealth-firms]