Why a small percent matters
A fee of 0.85% sounds like pocket change. But it is taken from the whole balance every year, including the growth you earned in earlier years, so it reduces the compounding itself. The effect shows up as a lower net return: 7% before fees becomes 6.15% after.
Net return = return before fees - expense ratio. The balance grows with monthly deposits at the net return, converted to a monthly rate as (1 + net return)^(1/12) - 1, with deposits at the end of each month. The return is the same every year, and taxes and trading costs are left out.
A worked example
Someone starts with $5,000 and invests $200 a month for 35 years in a fund earning 7% a year before fees. Over that time they put in $89,000. Compare a fund charging 0.85% with one charging 0.10%.
| Expense ratio | Net return | Final balance |
|---|---|---|
| 0.00% (no fee) | 7.00% | $395,666 |
| 0.10% | 6.90% | $386,427 |
| 0.85% | 6.15% | $324,219 |
The 0.85% fund costs $71,446 compared with no fee, which is 23% of all the growth the plan would have earned. The gap between the two funds is $62,208, and it comes from a 0.75 percentage point difference in fees. The 0.10% fund costs about $9,238 over the same period.
What to take from it
Fees are one of the few things in investing that you can see and control in advance. A fund's expense ratio is listed in its fact sheet, and a fee that is certain matters differently from a return that is only expected. Compare funds that hold similar things, such as two funds that track the same index, where a lower fee is the main difference.
A higher fee can be worth paying only if the extra return after fees really shows up, and that is hard to know ahead of time. The calculator holds the return before fees constant for both funds, which is the question a fee comparison asks. It is not a forecast of any fund's return, and it does not include sales loads, account fees or taxes.
Common mistakes
- Treating a fee in the low single digits as negligible. Over decades it takes a fifth or more of the growth.
- Comparing funds by last year's return without looking at what each one costs.
- Forgetting other costs, such as account fees, sales charges and trading costs, that add to the expense ratio.
- Assuming a higher fee buys a higher return. Over long periods, most higher-fee funds have not made up for the cost.
- Using a fee in the wrong units. Type 0.85 for 0.85%, not 85.
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