Fees and Compounding
A 0.03% and a 1% annual fee look similar, but after 30 years the gap is huge.
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Text version · Indexes & ETFs, lesson 5: “Fees and Compounding”
A 0.03% and a 1% annual fee look similar, but after 30 years the gap is huge.
Fees are charged every year, and compounding widens the gap
The expense ratio is taken out of the fund's assets every year. 0.03% and 1% both look tiny, but with compounding they drift further and further apart.
Tracking error
An ETF's performance always differs a little from its index. That's tracking error. Fees drag on NAV every day and are one of the main causes.
The management fee hides in NAV
The management fee isn't charged to your account separately; it's accrued daily from the fund's assets and shows up directly in NAV. A $20,000 holding at 0.5% costs about $100 a year: invisible, but always being taken.
Key takeaways
- The management fee is taken from fund assets daily and shows up in the NAV. You're never billed separately, but it's always being deducted.
- Fee gaps compound: at 7% a year for 30 years, a 1% fee leaves you about 24% less than a 0.03% fee.
- Tracking error: the gap between an ETF's performance and its index, with fees as one of the main sources.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click "Example": at 7% a year for 30 years, how much lower is the ending value of the 1% fund than the 0.03% one?
- Press ▶ from year 0: how far apart are the two funds after the first 5 years? And over the last 10?
- Set years held to 40: what does the percentage gap become?
- Drag Fund B's expense ratio to match A's: how much do fees eat now?
Quiz and explanations
- 1. At a 7% annual return over 30 years, how does the ending value of a fund with a 1% fee compare with one charging 0.03%?
- Answer: About 25% less.1.06³⁰ ≈ 5.74 and 1.0697³⁰ ≈ 7.55, a gap of about 24%.
- 2. What's one of the main sources of tracking error?
- Answer: Fund fees.Fees drag on the NAV every day.
- 3. You hold $20,000 of an ETF with a 0.5% expense ratio. Roughly how much do you pay in management fees over a year?
- Answer: $100.$20,000 × 0.5% = $100. It isn't billed separately; it's taken bit by bit from the fund's NAV every day.
Terms in this lesson
- compound interest (Compound Interest): Interest that earns interest of its own, so your money snowballs.
- expense ratio (Expense Ratio): The share of a fund's assets deducted each year to pay for running it.
- tracking error (Tracking Error): How much a fund's performance differs from the index it tracks.