Calculating the Compounding Drag of Fees — A 1% Difference After 30 Years
A 1% annual fee — it's only 1%, so what's the big deal, right? But when this 1% compounds over 20 or 30 years, it becomes a surprising size.
Fees Eat Away with Compounding
The reason fees are scary is that they "come out with compounding." When a fee is taken each year, the principal you have to invest the following year shrinks by that much. The reduced principal then generates that much less return, and this loss accumulates year after year.
Just as returns grow with compounding, fees eat away with compounding too. That is why the small number "1% a year" creates a gap that is by no means small decades later.
Seen Through the SEC's Official Example
The U.S. Securities and Exchange Commission (SEC) has a famous example in its investor-education materials. It assumes investing $100,000 at a 4% annual return for 20 years.
With a 0.25% annual fee, it becomes about $208,000 after 20 years.
With a 1.00% annual fee, it comes to only about $179,000 after 20 years.
The fee difference is only 0.75 percentage points, yet after 20 years the results diverge by about $30,000 (about 30% of the initial principal).
Source: U.S. SEC investor-education material "How Fees and Expenses Affect Your Investment Portfolio" (investor.gov / ib_fees_expenses.pdf). The 4% return over 20 years is an assumption for illustration, and the gap can grow even larger depending on the actual return and period.
The Longer the Period, the Wider the Gap
This example is 20 years; extend it to 30 or 40 years and the gap widens much more. Compounding grows more powerful the longer the time, and that applies equally to fee erosion as well as to returns.
This is why the longer your investment horizon, the more sensitive you should be to fees. An investment started when you are young enjoys the compounding effect for a long time, and so the fee difference accumulates for just as long. A single small choice to pick a low-cost product makes a big difference decades later.
よくある質問
Q. So is the cheapest product always the answer?
Cost is very important but not the only criterion. You should also look at tracking accuracy (tracking error), liquidity, and whether the asset composition fits your purpose. That said, the principle of "between similar products, choose the lower-cost one" is generally valid over the long run.
Q. If 1% is large, how large is a 20% performance fee?
A performance fee takes 20% of the profit when there is a gain, so in a good year it can be a far larger share than a 1% annual fee. The difference is that, with devices like the high-water mark, it is not charged until losses are recovered.
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