Brave New World: Flows versus Fundamentals

Brave New World: Flows versus Fundamentals

Valuation bubbles are euphoric but fleeting, driven by short-lived speculative flows. The 2000 Dot-com boom (December 1998 to February 2000) and the 2021 COVID surge (March 2020 to January 2021) each lasted around 12 months before the speculative herd ran out of steam. These episodes drove unsustainable valuation spikes, illustrating how speculative flows can rapidly inflate stock valuations to stratospheric heights before swiftly dissipating.

Source: FactSet

However, when overvaluation persists for years, it points to a structural force at play. Unlike the fleeting Dot-com and COVID bubbles, in recent years the overvaluation of large-cap stocks, particularly mega-caps, has been remarkably persistent. Large, mature companies like Australia’s Commonwealth Bank (CBA) and Wesfarmers (WES), and the United States’ Apple (AAPL) and Walmart (WMT) exhibited a surge in valuations starting from 2019, well before the COVID bubble.

Source: FactSet

This mega-cap overvaluation theme is now several years old—far exceeding the typical one-year lifespan of speculative bubbles. At what point do we acknowledge this is not fleeting exuberance but a profound structural change?

A recent research paper, “Passive Investing and the Rise of the Mega-Firms” (Jiang, Vayanos, and Zheng, 2024), offers key insights. The authors demonstrate how inflows into passive funds disproportionately elevate the prices of the largest firms. Mega-caps, with their dominant index weights, enjoy a systematic bias toward higher valuations—not from speculation, but from the mechanical arithmetic of market-cap-weighted allocation.

Passive investing: From Niche to Dominant Force

The origins of passive investing began modestly in 1976 when the Vanguard Group launched the first publicly accessible index fund. For decades, it remained a fringe option, with assets growing slowly through the 1990s while trailing active funds. But momentum built after 2015, as passive strategies overtook active ones in inflows. By 2024, passive funds had surpassed active in total assets under management (AUM), reshaping market dynamics through sheer dominance in both capital flows and overall share.

The rise of exchange-traded funds (ETFs) has supercharged this trend. Today, the four largest index ETFs in the US—Vanguard S&P 500 ETF (VOO), iShares Core S&P 500 ETF (IVV), SPDR S&P 500 ETF Trust (SPY), and SPDR Portfolio S&P 500 ETF (SPLG)—hold a combined US$2.2 trillion in assets under management (AUM), representing about 3.7% of the S&P 500's market capitalization. In Australia, counterparts like Vanguard Australian Shares Index ETF (VAS), iShares Core S&P/ASX 200 ETF (IOZ), SPDR S&P/ASX 200 ETF (STW), and BetaShares Australia 200 ETF (A200) manage approximately A$46 billion, or roughly 1.8% of the ASX 200. Collectively, these funds grew (excluding market movements) by 15% in the US and 20% in Australia over the past year. Maintaining these rates for the next three years could boost their sizes by 45% and 67%, respectively, further eroding active funds' market share.

Source: Bloomberg

Smart Beta: Quasi-Passive Amplifier

Passive investing's dominance has also sparked a boom in smart beta strategies, which blend passive market exposure with systematic tilts toward specific factors like higher dividends, value, or momentum. ETFs now span diverse themes, from clean energy (ICLN) and robotics (ROBO) to cybersecurity (CIBR) and even portfolio’s mimicking US Senators’ stock holdings (NANC and KRUZ). Demand for US smart beta ETFs has surged to the point where they outnumber the stocks listed on US exchanges.

Significant flows into smart beta funds are adding further fuel to mega-cap overvaluation, as many of these strategies rely on market-capitalization weighting as a baseline for portfolio construction. For example, the Vanguard Australian Shares High Yield ETF (VHY), which targets high-dividend-yield stocks, holds CBA as one of its largest absolute positions due to CBA's dominant index weight despite its modest yield. VHY's AUM stands at A$5.5 billion, having grown its units by 27% last year. If that pace continues, its AUM could reach A$7 billion (ignoring market movements), representing an additional A$1.5 billion in inflows over the coming year.

Source: FactSet

Superannuation: Australia’s Unique Amplifier

Australia presents an additional structural layer through it’s A$3.9 trillion superannuation industry. The 2021 introduction of the MySuper Performance Test, under the Your Future Your Super reforms, has inadvertently accelerated the shift toward passive investing. Administered by the Australian Prudential Regulation Authority (APRA), the test compares funds' eight-year annualized returns against benchmarks for each asset class. Underperforming products face closure or forced mergers. To avoid regulatory scrutiny and penalties, many superannuation trustees have embraced "benchmark-hugging" strategies. This pivot funnels trillions into passive-like strategies, further reinforcing the structural overvaluation of Australian mega-caps.

Conclusion

In this brave new world of investing, fleeting speculative flows can still flare up, but structural inflows from passive strategies have redefined market norms. What began as a democratizing force has ballooned into a juggernaut, embedding overvaluation into mega-caps through relentless, arithmetic-driven allocations. If these trends persist—and there's little sign of slowdown—mega-caps’ valuations in general will likely remain stubbornly elevated. In a flow-dominated landscape, fundamentals alone no longer dictate valuations, especially for mega-caps. Adapting means recognizing that these giants aren't just leading the pack — they're engineered to outlast it.

Reference:

Jiang, H., Vayanos, D., & Zheng, L. (2025). Passive investing and the rise of mega-firms. Review of Financial Studies