T Rowe Price: The hidden impact of artificial intelligence on markets

Investors have spent much of the past two years focused on artificial intelligence. They may have overlooked another important development – AI is now reshaping the benchmarks that trillions of dollars track.

For example, the recent reconstitution of the Russell was one of the largest passive flow events on record, with about $320bn of turnover associated with the reconstitution alone, more than double last year’s record event.

The next S&P quarterly review is expected to generate roughly $107bn in two-way flows, while recent methodology changes across major index providers could result in substantial passive demand for SpaceX, with cumulative buying potentially exceeding $100bn over the next year.

Those numbers are significant. But the more interesting question is why events like these have become so important in the first place.

Twenty years ago, index reconstitutions were largely viewed as technical exercises. Stocks moved between benchmarks, portfolio managers adjusted positions, and markets moved on. Today, the consequences can be far more significant.

Many of the biggest beneficiaries of the AI boom have appreciated dramatically over the past two years

What appears to be a routine benchmark refresh can alter risk exposures, influence capital flows, affect liquidity and reshape portfolio outcomes across entire segments of the market. The reason is simple – markets have changed.

A redistribution of risk

At first glance, the reconstitution offered another example of investors chasing the winners of the AI era. Many of the biggest beneficiaries of the AI boom have appreciated dramatically over the past two years, moving rapidly up the capitalisation spectrum and increasingly finding their way into growth-oriented benchmarks.

As those companies migrate through the index ecosystem, passive capital follows automatically. Investors are not simply receiving a refreshed benchmark; they are receiving a different risk profile.

Growth indices are becoming more exposed to AI-related themes, momentum and higher-beta stocks. Smaller-cap and value benchmarks are simultaneously losing some of those exposures. What often looks like a routine index update is, in reality, a significant redistribution of risk across size, style and thematic exposures.

Trillions now move according to benchmark methodologies rather than individual investment decisions

But the real story extends far beyond AI. This year’s reconstitution highlighted a much broader transformation taking place across financial markets.

For decades, markets were dominated by active investors making decisions based primarily on company fundamentals. Capital flowed toward businesses investors believed would generate superior earnings, cash flows and returns. Understanding markets largely meant understanding companies. That is no longer enough.

Over the past two decades, passive investing has grown from a niche strategy into one of the dominant forces in global markets. Trillions now move according to benchmark methodologies rather than individual investment decisions.

At the same time, retail participation has expanded, options activity has surged, and quantitative and systematic strategies account for a growing share of daily trading activity. The balance of influence has shifted.

T Rowe Price: The AI story is powerful. Valuations are the question

Understanding modern markets increasingly requires understanding ownership structures, incentives and flows, and not just earnings forecasts and valuation multiples. Who owns an asset? How do they own it? Under what conditions will they buy or sell?

These questions have become increasingly important in explaining market behaviour. The consequences are visible everywhere.

More than just fundamentals

Market recoveries have become faster as investors have become conditioned to buy weakness. Passive inflows continue regardless of valuation. Quantitative strategies react systematically to market signals. Retail participation can amplify narratives and momentum.

Volatility at the stock level remains elevated, while volatility at the index level often appears remarkably calm

Meanwhile, index volatility often appears subdued even as individual stocks experience significant swings.

In many ways, today’s market is characterised by a paradox: volatility at the stock level remains elevated, while volatility at the index level often appears remarkably calm.

At the same time, concentration has increased. Capital flows disproportionately toward benchmark leaders, reinforcing the performance of the largest and most influential companies. Ownership and flows increasingly shape the path prices take, even if fundamentals ultimately determine long-term value.

This does not mean fundamentals no longer matter. Over time, earnings, cash flows and competitive advantages remain the primary drivers of value creation. But understanding markets today requires more than understanding fundamentals. It requires understanding the structure of the market itself.

Over time, earnings, cash flows and competitive advantages remain the primary drivers of value creation

That is why this year’s Russell reconstitution mattered. Not because it generated hundreds of billions of dollars in trading activity. Not because AI winners moved between benchmarks. And not because it created short-term opportunities for traders. It mattered because it provides one of the clearest examples of how modern markets now function.

The recent reconstitution made visible forces that are otherwise easy to overlook – passive ownership, benchmark-driven capital allocation, thematic concentration, systematic flows and changing patterns of price discovery.

The headlines usually focus on turnover, benchmark additions and deletions, and the mechanics of implementation. But those are symptoms rather than the story. The real story is that markets are undergoing a structural transformation.

Justin Thomson is head of the T Rowe Price Investment Institute