When the Cheapest Option Isn’t Always the Best

Gerald Ratner joined his family’s jewelry business in 1966 and built it up into an incredibly successful high street chain during the 1980s.

People loved Ratners stores because they offered affordable products to the man and woman on the street.

However, everything came crashing down on April 23rd 1991 when he was invited to be a guest speaker at a dinner hosted by the Institute of Directors.

Upon being asked how it was possible for his company to sell sherry decanters for the extraordinarily low price of £4.95 in front of a 6,000-strong audience of journalists and business people, he answered, to the amazement of those in attendance (that included a significant number of his company’s shareholders) – “How can you sell this for such a low price? I say, because it’s total crap.”

To make matter even worse he also said that his company “sold a pair of earrings for under a pound, which is cheaper than a shrimp sandwich from Marks & Spencer, but probably wouldn’t last as long.”

The media predictably had a field day and the share price collapsed.

Ratner’s speech remains infamous in the corporate world as a stark example of the value of branding and image over quality.

Why the cheapest option isn’t always the best for investors

We have always been advocates of low-cost investing in Ireland, pioneering the introduction of passive investment options from Vanguard for example.

However, an obsession with seeking out the lowest cost option isn’t necessarily always in investors best interests.

Take global equities over the last year for example. We know for a fact that many brokers have been piling their clients into the lowest cost options that they can find and shunning more complex portfolios which cost a little more.

Let’s compare three funds with a Global Equity mandate

Ongoing Charges (previously Total Expense Ratios or TERs) is a figure published annually by an investment company which shows the drag on performance caused by operational expenses.

From this we can see that the Vanguard Global Smaller Companies Index has nearly twice the ongoing management cost of the Global Stock Index and the Dimensional Fund is exactly 3 times the cost.

Many, if not most, financial advisers in Ireland see their job as putting the cheapest option in front of their clients like they are selling car insurance.

Whilst we agree that cost is a relevant and indeed important consideration for investors, in numerous studies, Asset Allocation decisions have been shown time and time again to explain the lions share of the investment returns that investors actually earn.

Asset allocation is just a fancy way of saying the mix of investments that go into a particular investors portfolio. Asset classes include lower risk options like cash and bonds and more risky options like Equities and Real Estate. Within each asset classes are different sub-classes such as more defensive quality equities or higher risk smaller companies.

Getting the right mix of these asset classes is critical to ensuring that investors are appropriately rewarded for the investment risks that they take.

So, how did that lowest cost option perform over the last year compared to the more expensive options.

I’m quite sure many investors would have been absolutely delighted with a return of 50.61% over the last 12 months and not thought twice about it.

But as investment advisers we are also interested in relative performance. We can see that the more expensive Global Targeted Value fund has delivered almost twice the return over the same period, more than justifying an additional 0.36% in charges.

This is exactly what we advised our clients to do a year ago because, whilst we recognise the importance of keeping costs down, we also understand the importance of good asset allocation in portfolio design.