Passive investing has always been celebrated for its simplicity, low fees, and solid long-term returns. But beneath that glossy surface lies a growing structural problem: the collapse of genuine diversification. As trillions flow into market-cap-weighted (MCAP) indices like the S&P 500 (SPY) and its global counterparts, something profound is happening—different regions and sectors are no longer moving independently. Rather than charting their own courses, they’re dancing to the same tune, not because of some grand economic alignment, but because money is concentrating in the same few mega-cap names.
In a healthy market ecosystem, a Brazilian bank should not mirror a Californian tech giant, nor should Indian infrastructure stocks track a British oil conglomerate. Yet when we compare the S&P 500 to other major regional indexes—from Canada’s TSX 60 and Europe’s STOXX 50 to India’s Nifty 100 and Brazil’s Bovespa—the correlations are stunningly high. Canada, for instance, logs a 0.96 correlation with the S&P 500, while Europe comes in at 0.95. These numbers suggest near-identical behavior, which implies that buying into multiple major indexes might be little more than re-buying the same trade. That’s not diversification—it’s duplication. Now, consider what happens when you shift focus to U.S. small-cap indices like the S&P SmallCap 600 (IJR) or the Russell 2000 (IWM). Their correlations to those same global markets are markedly lower, sometimes dipping into the 0.60s or even below. The explanation is simple: small-cap companies depend on local consumers, supply chains, and policy changes, and they’re not swept up in global ETF inflows. This contrast proves a key point: correlation diversity is still alive, just not where MCAP passive capital sets the agenda. The idea is to ignore the large-cap and buy the small-cap, the idea is to move away for MCAP weighting methodology as it converges everything into itself, destroying dispersion and hence the concept of diversification.
High correlation in itself is not inherently bad; it’s a sign of how markets interact. But when everything moves in lockstep due to passive megacap flows, the dangers multiply. Investors think they’re diversified when they’re not, risks that should remain local become systemic, and when volatility hits, it hits everywhere at once. During events like the COVID crash or sudden inflation scares, we watched global ETFs touted as “diversified” tumble in unison with the S&P 500, exposing just how superficial that diversification really was. The overlapping top holdings, identical structures, and synchronized flows mean that even international ETF buyers might be repurchasing the same big names under different banners.
That’s the core flaw of passive megacap investing. The largest stocks dominate index behavior, so whether it’s Apple and Microsoft in SPY, Nestlé and ASML in STOXX 50, or BHP in ASX 200, you’ll see capital pile into a handful of mega-caps, pushing genuine diversity off the table. On paper, portfolios may look varied. In practice, they behave identically. This uniformity severs our ability to exploit local dislocations, turning global markets into a single ETF-driven bet. And when everything is bought (or sold) together, there’s nowhere left to hide.
If you want true diversification—a mix of assets that behave differently—you need to break free from the gravitational pull of MCAP passive. Equal-weight or factor-weighted strategies are one route; smaller-cap allocations that capture local nuances are another. Or you could explore active strategies that prioritize uncorrelated returns. MCAP passive investing isn’t useless, but the colossal scale at which we’ve adopted it has created a monoculture. We’ve sacrificed the core benefit of financial markets—independent behavior—for the sake of low fees and simplicity.
So, does MCAP passive kill correlations? In many ways, yes—and with them, it kills real investment choice. As we chase the same mega-cap names in every corner of the globe, diversification becomes more of a marketing tagline than a protective shield. We’re not building safety; we’re building fragility. And once correlation diversity is lost, it rarely comes back on its own. It’s time to think differently about how we invest, because the structure of our portfolios matters just as much as the markets we tap into. When everything moves in unison, the fundamental promise of diversification becomes nothing more than an illusion.
Mukul Pal