Just caught something interesting about the passive investing trend that's been dominating markets for the past decade or so. Terry Smith, the British fund manager everyone calls the "English Buffett," just put out a pretty stark warning in his latest shareholder letter.

Here's what's bugging him: over the last 20 years, we've seen an absolutely massive shift in how big investment companies and regular investors allocate capital. Passive index funds have basically taken over. They're cheaper, they're easier, and honestly, most active funds underperform after fees anyway. Even Buffett himself has been pushing index funds for years.

But here's where it gets interesting. Smith is pointing out that this shift is creating some pretty dangerous distortions in the market. When capital flows into index funds, it doesn't care about valuation or company quality - it just mechanically buys whatever's in the index. That means the biggest companies get disproportionately more capital flowing into them, which can send prices way higher than their actual intrinsic value justifies.

Think about it this way: when big investment companies managing passive funds have to buy shares just to match an index, they're creating inelastic demand. At the same time, most large companies are reducing share count through buybacks, so supply is inelastic too. A dollar flowing in doesn't necessarily mean the business got better - it just means prices go up.

Smith writes that this is "laying the foundations of a major investment disaster." His concern is that if investor sentiment shifts and capital starts flowing out of stocks into bonds or cash, you could see a severe and prolonged sell-off, especially in stocks that have gotten way overvalued from all this passive money pouring in.

So what's his solution? Pretty simple actually. Buy good companies at fair prices and don't do much else. Quality stocks that have strong returns on equity, stable earnings, and low debt have historically beaten the broader market over every 10-year period since 1999. They also hold up better when things get ugly.

The strategy won't beat the market every single year - Smith's own fund had a rough 2025 for exactly this reason. But over time, focusing on quality at reasonable valuations is how you actually build wealth without getting caught up in the distortions that big investment companies are creating through passive index flows. Worth thinking about if you're concerned about where valuations are headed.