Passive investing has become a popular choice for many investors due to its simplicity, low cost, and simple access to compounding returns.

So what is passive investing?
Passive investing is an investment strategy that involves buying and holding a diversified portfolio of assets, such as shares, fixed interest, and property, in order to match the performance of a specific market index. The goal is to achieve compounding returns faster by minimizing trading costs and avoiding the risks associated with actively picking individual stocks.
I recently watched this video, and to save you the time, here are the key insights:
In recent years, passive investing strategies have gained significant popularity among investors in New Zealand and around the world. These strategies involve investing in market-tracking funds, such as index funds and exchange-traded funds (ETFs), that aim to replicate the performance of a particular index, such as the S&P 500 or the NZX 50. However, there are concerns that the rapid growth of passive investing may have unintended consequences on financial markets. 
The Rise of Passive Investing: Passive investing has become increasingly popular due to its low costs, and the ease at which investors can access diversification. By investing in a broad market index, investors can avoid the risks associated with individual stock picking and reduce the [relatively higher] costs of active management. However, as more investors shift their funds into passive investment vehicles, there are concerns that this trend may lead to market distortions and deviations from fundamental values.
Here’s where we need to explore ‘Index Arbitrage and ETF Creation’. Two key factors contributing to market distortions are index arbitrage and ETF creation. Index arbitrage involves taking advantage of price differences between a share index and its derivative products, such as ETFs (Exchange traded funds). This can lead to market distortions and deviations from fundamental values. ETF creation involves the process of creating new ETF shares by authorised participants (APs) who buy the underlying securities and exchange them for ETF shares. 
Break it down even more?
  1. Index Arbitrage: This is a strategy used by investors to make a profit from the difference in prices between a share index (a collection of shares representing a particular market or segment) and its derivative products (financial instruments that derive their value from the underlying index). For example, if an ETF that tracks the S&P 500 index is trading at a lower price than the value of the shares in the index, an investor might buy the ETF and sell the shares in the index, making a profit from the price difference.
  2. Market distortions: These are situations where the market prices of financial instruments (like shares and ETFs) deviate from their fundamental values. This can happen due to various reasons, including index arbitrage. When a lot of investors engage in index arbitrage, it can lead to a significant price difference between the index and its derivative products, causing market distortions.
  3. ETF creation: This is the process of creating new shares of an ETF. It is done by ‘authorised participants’ (APs), who are typically large financial institutions. The APs buy the underlying stocks that make up the index the ETF is tracking and then exchange these stocks for new ETF shares. These new shares are then sold in the market, increasing the supply of the ETF.
The Shift from Defined Benefit to Defined Contribution Plans: Another factor contributing to the growth of passive investing is the shift from defined benefit plans to defined contribution plans. In the past, many workers in the US were covered by defined benefit pension plans, which provided a guaranteed retirement benefit based on salary and years of service. However, these plans have been replaced by defined contribution plans, where the final retirement benefit depends on the performance of the underlying investments. This has led to a greater reliance on passive investment vehicles, as individuals must choose their own investments.
Break it down again?
  1. Defined benefit plans: In the past, many US workers had a retirement plan called a ‘defined benefit’ plan. In this plan, the employer promised to pay a certain amount of money to the employee after they retired. This amount was based on the employee’s salary and how many years they worked for the company. The employer was responsible for making sure there was enough money in the plan to make these payments.
  2. Defined contribution plans: Now, many workers have a different kind of retirement plan called a ‘defined contribution’ plan. In this plan, the employer, employee, or both contribute a certain amount of money into an investment account. The final amount of money the employee will have at retirement depends on how well the investments in this account do. The employee is responsible for choosing the investments.
  3. Shift from defined benefit to defined contribution: There has been a shift from defined benefit plans to defined contribution plans. This means that more people now have to choose their own investments for their retirement. As a result, many people choose to invest in ‘passive investment vehicles’, which are investment funds that track a market index and require less active management. This is because they are generally low-cost and have performed well over the long term.
The Potential for a Market Reversal: The rapid growth of passive investing has led to concerns that a sudden shift in investor sentiment or a significant market event could trigger a violent market reversal. This is because passive investing can lead to a concentration of assets in a few large companies, which may not accurately reflect the underlying fundamentals of the market. Many investors may not fully understand the potential consequences of a market reversal.
Conclusion: While passive investing strategies offer several benefits, such as low costs and diversification, they also have the potential to distort market prices and deviate from fundamental values. As New Zealand investors increasingly rely on passive investment vehicles, it’s important to be aware of the potential risks and to consider the implications of a market reversal. Passive investing should save money and allow easier access for Kiwi’s to invest – it’s not an excuse to take the word ‘passive’ literally, and intellectually ‘check out’.