As you will have seen in numerous media reports, Neil Woodford – one of the UK’s best-known fund managers – recently had to suspend trading in the actively-managed Woodford Equity Income Fund.

At its peak, the fund held over £10billion of investments but at the time of writing, held less than £4billion. To summarise very briefly what went wrong, when the performance of the fund did not live up to expectations – Woodford’s previous successes had driven initial enthusiasm – investors began to lose confidence and attempted to remove their money. The subsequent exodus caused substantial problems because many of the investments could not quickly be turned back into cash.

While the financial future remains uncertain for Woodford’s concerned investors, the key lesson to be learned is that active management adds additional layers of risk to portfolios.

In a world where markets work pretty well and active manager fees are high relative to likely skill, one should question whether these risks are worth taking. The Woodford case provides a useful reminder of the challenges and dangers of doing so.

With actively managed investment funds, a professional fund manager makes all the investment decisions, such as which companies to invest in or when to buy and sell different assets. The investor therefore, must pay for the manager looking after their fund and the team researching markets and companies. Note that even during this time of hiatus, Woodford has refused to drop their charges on the locked-in funds and daily fees have been estimated at more than £75,000. Woodford himself enjoyed a 65% stake of a £35million dividend last year.

On the other hand, passive or index investment funds are designed to track an index, market or asset class. The funds essentially buy all of the assets in a particular market to give you a return that reflects how the market is performing.

Numerous studies show that a passive approach, using well-diversified portfolios that capture market returns as Cavendish advocates, makes very good sense.

In 2013, Professor Eugene Fama of the University of Chicago was named as a joint winner of the prestigious Nobel Prize for Economics following his 50 years of academic research into financial markets. His lifetime body of work explains that we are better off letting the market work for us – taking a passive approach – rather than struggling to adopt complex, expensive strategies to ‘beat’ the market.

Fama’s studies show that market prices incorporate all available information. It states that we cannot systematically outperform the market, unless we have information other people do not or can access part of the market others cannot. That does not mean it is impossible to make money – just that returns come from risk rather than stock picking or market timing.

There is much academic debate around the degree to which luck plays a role in investment returns. We know that owning a portfolio significantly different to the broad market, means that there will inevitably be periods of time when the investment thesis will be right (or lucky) and other times when it will be wrong (or unlucky). Our view is that it is mainly luck and that the evidence suggest that only a handful of managers are skilled enough to deliver returns that exceed their costs and they are hard to identify in advance.

Despite the hard empirical evidence that active management cannot be relied on to deliver the outperformance it promises, many investors continue to believe that past fund performance is a guide to future activity, despite the clear warnings in place.

Active management certainly has an easier sell – the idea of investing in a ‘best’ fund, rather than an ‘average’ one is much more appealing. Despite this, there are some important points for investors to remember:

1. Risk and return go hand-in-hand: if you own an actively managed fund that is quite different to the market, it returns will be too, both on the up and the downside.

2. Skill is very rare, and luck plays a major role in most active managers’ periods of outperformance. Markets work pretty well, and market-beating performance is likely to come only from taking on higher risks e.g. owning smaller companies. After costs, the empirical evidence suggests that very few active managers deliver skill-based returns sufficient to cover their costs over the sort of horizons that investors require.

3. In the same way that noise and luck play a big role in fund manager outcomes, so it does when trying to pick active funds. Best-buy lists and advisers active fund picks are highly susceptible to this noise.

4. Concentrated stock positions, combined with low levels of liquidity, is a dangerously potent cocktail that represents a material risk to investors’ wealth. In our article last month, we discussed the importance of diversification.

5. High levels of diversification in liquid, quoted companies, ensuring that no small set of companies dominates outcomes, is essential. That is why the total number of stocks held in Cavendish clients’ portfolio is up in the thousands.

6. Gambling on which fund is going to beat the market is an exceptionally low probability strategy. Capturing the market return is a valid and worthy objective.

The Woodford saga reminds us that investing is a tricky game, which can have material costs if you get it wrong. It is hard enough owning the equity market, without the added additional risks of active management. Instead, we believe that a systematic, well-diversified, low cost approach to investing that avoids active manager, concentration and liquidity risks, is the sensible way to go.