Passive Investing is Impassive on Valuation

It’s difficult to approach the topic of passive investing without acknowledging one’s own inherent bias. After all, careers have been built on the premise that active investing adds value. No matter how much we try and attempt to set biases aside – your author know they are unlikely to succeed.
The rise of passive investing has reshaped global financial markets, offering investors low-cost, diversified portfolios that often track major indices. New Zealand is no exception. The proportion of funds flowing into passive vehicles has steadily increased, and while the appeal is undeniable—especially given that S&P’s SPIVA survey shows 77% of large-cap equity funds underperformed the S&P index on a net-of-fees basis over the five years to June 2024—the unintended consequences of this shift, particularly for the NZX50, deserve closer scrutiny.

Passive Investing’s Growing Influence in New Zealand

Passive inflows now account for more than 50% of all inflows into US markets (Source: Morningstar, 2023) and New Zealand is no different, with the share of investment funds flowing into passive vehicles steadily increasing year over year. KiwiSaver’s rapid expansion has been a significant driver of this growth, with multiple default funds utilising passive strategies to minimize costs. While these products make investing more accessible and affordable, they also have the potential to distort smaller markets like New Zealand’s.

When passive investors buy an ETF that tracks the NZX50, capital is allocated based on market capitalization rather than company fundamentals. This can create a self-fulfilling prophecy—larger companies receive more investment, inflating their valuations regardless of their underlying performance. In contrast, active investors play a crucial role in price discovery by analysing fundamentals and allocating capital accordingly. However, as passive inflows grow, this mechanism weakens, and prices begin to reflect index inclusion rather than company-specific merit. The smaller and less liquid a market, the more likely the impacts are going to be meaningful.

Fisher & Paykel Healthcare: A Case Study in Valuation Distortion

The distortive effects of passive investing can be seen in several instances—but one example at the forefront of my mind is Fisher & Paykel Healthcare (FPH). As the largest constituent of the NZX 50, FPH currently accounts for a staggering 17% of the index. This means that any investment into an NZX 50-tracking ETF results in significant capital flowing into FPH, irrespective of its valuation or fundamentals.