The Strange Attractor

Part 2 of The Sovereign Series: How Passive Investing Created an Inescapable Loop

Erik Bethke + Claude | January 1, 2026

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In the year 2000, about 3% of the US stock market was held by passive index funds.

Today, that number exceeds 50%.

This is not a minor shift. It's a phase transition in how prices are set, power is allocated, and futures are determined. And almost no one is talking about what it actually means.

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The Numbers

| Year | Passive Share of US Equities | |------|------------------------------| | 2000 | ~3-5% | | 2010 | ~15-20% | | 2020 | ~41% | | 2024 | ~50%+ (passive overtook active in 2023) |

Meanwhile, algorithmic and high-frequency trading has grown from roughly 10% of equity trading volume in 2000 to somewhere between 50-70% today.

The upshot: markets are no longer primarily driven by human decisions about value. They're driven by passive fund flows and algorithmic execution that respond to those flows.

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The Loop

Here's the structure that created the Magnificent Seven's dominance:

Passive investing grows
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         v
Index funds buy the index
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         v
The index is market-cap weighted
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         v
Biggest stocks get the most dollars
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         v
Their prices rise
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         v
Their market cap grows
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         v
Their index weight increases
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         v
Passive funds must buy more of them
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         v
Their prices rise further
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         v
Active managers underperform
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         v
More money flows from active to passive
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         v
[Return to top]

This is a strange attractor - a self-reinforcing dynamic that looks stable but is actually trapped in a loop that could snap unpredictably.

Why Active Managers Can't Win

The logic is brutal:

1. Active managers charge higher fees than passive funds
2. Active managers are benchmarked against the index
3. The index is driven up by passive flows regardless of fundamentals
4. To beat the index, active managers must be more concentrated in the biggest stocks than the index
5. But they can't be - that's just the index with extra steps and higher fees
6. So they underperform
7. So money leaves them for passive
8. Which drives the index up more
9. Which makes them underperform more

Passive investing parasitizes the price discovery that makes markets work - while systematically destroying the infrastructure that does that price discovery.

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The Concentration

The loop doesn't just reinforce itself. It concentrates itself.

| Metric | Historical Average | 2000 (Dot-Com Peak) | 2024-2025 | |--------|-------------------|---------------------|------------| | Top 10 stocks as % of S&P 500 | ~20-25% | ~27% | ~40-41% (all-time record) |

Let's do the math:

• ~50% of the market is passively held
• ~40% of the index is just 10 stocks
• Therefore: ~20% of the entire US stock market is passive money concentrated in just 10 companies

And it's even more concentrated than that suggests. The "Magnificent 7" alone:

| Company | Approx S&P 500 Weight | |---------|----------------------| | Apple | ~7% | | Microsoft | ~7% | | Nvidia | ~6% | | Amazon | ~4% | | Alphabet | ~4% | | Meta | ~2.5% | | Tesla | ~2% | | Total | ~32-35% |

Seven stocks. One-third of the index.

When you "diversify" into an S&P 500 index fund, you're not buying "the market." You're buying a leveraged bet on seven tech companies with 493 other stocks along for the ride.

The diversification passive investing promises is increasingly a fiction.

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The Buyback Alchemy

But wait - it gets worse. The Magnificent Seven aren't just benefiting from passive flows. They're amplifying them with their own balance sheets.

The buyback loop:

Generate massive cash flows
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         v
Buy back shares (reduce float)
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         v
EPS rises mechanically (same earnings / fewer shares)
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         v
Stock price rises
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         v
Market cap increases
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         v
Index weight increases
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         v
Passive funds must buy more
         |
         v
Stock price rises more
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         v
[Repeat]

The Mag 7 spent over $250 billion on buybacks in 2024 alone. They're not subject to the market. They're manipulating the market using their own monetary policy.

This is why I argued in Part 1 that they've become sovereign entities. They print and destroy their own currency (shares) to optimize their position in a system that must buy them regardless of fundamentals.

They're playing a different game than everyone else. And the rules of their game are ones they write.

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The Price Discovery Paradox

Here's the paradox that should keep economists up at night:

Markets work because active investors do price discovery. They analyze companies, estimate future cash flows, identify mispricing, and trade on that information. The aggregate of their decisions is what makes prices roughly correspond to value.

Passive investing free-rides on this work. Index funds don't analyze. They don't estimate. They just buy the index. They assume that the price discovery has already happened.

But as passive investing grows, there are fewer active investors doing price discovery. As active investors shrink, the quality of price discovery degrades. As price discovery degrades, prices detach further from fundamentals. As prices detach from fundamentals, active investors either:

• Give up and go passive (accelerating the problem)
• Or try to exploit the mispricing (but there's no one to correct against)

Passive investing is parasitic on the very mechanism it's destroying.

At 3% passive, this wasn't a problem. Price discovery was robust. Passive funds were a rounding error.

At 50% passive, we're in uncharted territory. What happens when half the market just buys the index regardless of what's in it?

At 70% passive? 80%?

At 100% passive, price becomes purely reflexive. A hall of mirrors with nothing real at the center. The index would be:

"These are the most valuable companies." "Why are they valuable?" "Because they're in the index." "Why are they in the index?" "Because they're valuable."

The map would become the territory. Except there would be no territory - just map all the way down.

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The Metastable State

In physics, a metastable state is one that appears stable but is actually precarious. A ball balanced on a hill. Supercooled water that's below freezing but hasn't crystallized. Everything looks fine until a small perturbation tips the system into a new regime.

I believe we're in a metastable state.

Signs of precarity:

• March 2020: COVID trigger caused the fastest crash in history, followed by the fastest recovery. The speed in both directions suggests a system that's lost dampening mechanisms.

• Meme stock saga: GameStop and AMC demonstrated that price can completely detach from fundamentals when enough flow hits a thin float. The mechanisms that would have corrected this were absent.

• Flash crashes: Increasingly frequent brief, violent price moves that correct themselves - glimpses of what happens when the algorithms panic.

• Volatility suppression: The VIX has been anomalously low relative to underlying risks. When everyone buys the index, day-to-day volatility compresses. But this creates correlated fragility - when everyone sells, they sell everything at once.

The compression of volatility isn't stability. It's a loading of the spring.

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Why There's No Natural Exit

Here's what makes this truly structural, rather than merely cyclical:

To break the loop, you'd need:

1. Mass retirement withdrawals - Boomers selling their index funds. But they'll sell slowly, and into what? They'll die before it unwinds.

2. Active managers to return - But they've been destroyed. The talent is gone. The infrastructure is gone. The fee structure that could support them is gone.

3. Regulatory intervention - Break them up? The regulators are captured. And break them up with what authority? Using what infrastructure? The coordination needed to break up these companies would have to run on their platforms.

4. A competitor to emerge - From where? They control compute, cloud, distribution, attention, talent, and capital. The barriers to entry are civilizational.

5. A black swan event - Maybe. But they're so diversified internally and so cash-rich they'd buy the crisis. They'd be the acquirers, not the acquired.

There is no natural predator. The loop is structural and self-reinforcing. It doesn't have a termination condition that isn't either external shock or the heat death of economic meaning.

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The Buffett Signal

Warren Buffett - the most patient, long-term, "believe in America" investor in history - is currently sitting on $382 billion in cash.

The man who said "cash is a terrible investment" has more cash than ever. The man who said "never bet against America" is selling his most American positions (Apple, Bank of America).

One interpretation: He's preparing for a crash and will buy the dip.

But there's a problem with that interpretation. $382 billion could buy the bottom 479 companies in the S&P 500. Buffett has never bought mediocrity at scale. That's not his game.

A better interpretation, I think: He's cleaning house for succession. At 94, he's not making a market call. He's removing his thesis from the board so his successor inherits a blank canvas, not embedded positions they didn't choose.

But either way, the signal is: the greatest investor of our era is holding cash while everyone else piles into passive index funds.

Either he sees something coming, or he sees nothing he understands well enough to bet on.

Both interpretations are concerning.

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Index Inclusion as Political Act

Here's a thought that doesn't get enough attention:

Who decides what's in the S&P 500?

A committee at S&P Global. A handful of people who make decisions that direct trillions of dollars.

When a stock gets added to the index:

• Passive funds must buy it
• The stock jumps regardless of fundamentals
• The company's cost of capital drops
• Its ability to issue equity improves
• Its talent recruitment improves (stock-based comp worth more)

When a stock gets removed:

• Passive funds must sell it
• The stock craters regardless of fundamentals
• The company's cost of capital rises
• Death spiral risk

Index inclusion has become a political act - one of the most consequential in finance. But we treat it as neutral. Technical. Just "measurement."

It's not measurement. It's selection. And the selection determines where the river flows.

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What Would Taking This Seriously Look Like?

If we took the strange attractor seriously, we might:

1. Recognize that "the market" doesn't mean what it used to. Price is increasingly detached from fundamental value. Using market cap as a measure of worth is circular when market cap is driven by flows that ignore worth.

2. Question the retirement system's dependence on index funds. The 401k/IRA infrastructure assumes passive investing is safe and "the market always goes up." But if passive investing is itself creating the conditions for systemic risk, we're building retirement security on quicksand.

3. Recognize index committee decisions as governance decisions that should have transparency and accountability proportional to their impact.

4. Consider structural interventions - not to punish success, but to maintain the conditions for competition. (More on this in Part 3.)

But mostly, taking it seriously means seeing it clearly - naming what has happened without assuming someone else has a plan to fix it.

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The Uncomfortable Conclusion

The strange attractor wasn't designed. No one sat in a room and planned this. It emerged from:

• Efficient market theory (just buy the index)
• Fee compression (passive beats active on costs)
• Retirement policy (401ks default to target-date funds)
• Human laziness (set it and forget it)
• Network effects (the index gets stronger as more join)

Each piece made sense individually. No one was wrong exactly. But the aggregate outcome is a system that:

• Concentrates power in seven companies
• Destroys the price discovery mechanism
• Creates correlated fragility
• Has no natural exit
• Is load-bearing for everyone's retirement

We built a trap and then climbed into it together.

The question isn't who to blame. The question is whether it's possible to see clearly enough to maintain optionality for the future.

In Part 3: The Empty Throne, we'll examine why almost no one is talking about this - and what simple structural changes could keep the light cone open.

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This is Part 2 of The Sovereign Series. Part 1: The New Sovereigns establishes the frame. Part 3: The Empty Throne explores the silence and what might be done.