GLOBAL- Passive investment may be popular but it is undermining equity market returns, promoting bubbles and implosions, and costing pensioners their savings, says Paul Woolley, chairman of the e27bn fund manager GMO Woolley.

Speaking at a debate in London sponsored by the Society of Investment Professionals, he condemned the shift towards indexing and an obsession with tight tracking error, trends he suggested are becoming apparent in all the major overseas markets.

“By going passive, investors are abdicating their market power in favour of the corporate issuers – the companies raising funds in the market through IPO’s, rights and other issues.

“Index tracking makes sense for the individual fund but collectively everyone suffers. The growing dominance of tight tracking strategies is resulting in the mispricing of securities, misallocation of capital, and wealth being transferred from UK investors to issuers, governments and foreign investors,” he says.

Indexed funds now account for an estimated 30% of the UK equities market, while another 30-40% is thought to be closet-indexed. He cites the example of Vodafone as damaging market efficiency.

Woolley suggests Vodafone’s spending spree was funded by investor inertia in that the telecoms company’s growth by foreign acquisition forced indexers to reweight their portfolios continually, regardless of the share price.

At the peak, Vodafone represented almost 13% of the FTSE 100 index. Given the subsequent share price collapse, says Woolley, investors would have saved money if Vodafone had gone bust in 1999.

“Issuers are able to exploit rule-following trackers in a number of ways and then use the funds in unproductive ventures. Passive investing and index obsession bears much of the blame for the TMT bubble and for the resource misallocation that resulted from it.

“Inelastic demand fosters bubbles and implosions; with pure and closet indexers accounting for two-thirds of the market, they ensure that a small bubble becomes a massive bubble.”

Predicting a price implosion that could wipe out a major stock or even a sector, Woolley says that indexers will simply stand on the sidelines in any such disaster and declare it to be “the will of the gods”.

“Free-riding passive investors and tight trackers should recognise that their index obsession is damaging the reputation of our markets, the future security of our pensioners and the wealth of this country,” he says.