How fees eat returns

The price of investing

Investing is not free. Someone runs the fund, someone carries out your order, someone converts your money into dollars. Each of them is paid, and every payment comes out of your money. None of these costs is a scandal; they are the price of the service. What matters is knowing which ones you pay, and how much they add up to over the years.

The yearly cost of a fund

A fund charges for running itself — the managers, the administration, the record-keeping. The total is stated as a yearly percentage of the money in the fund, called the expense ratio. A fund with a 0.5% expense ratio costs about $50 a year for every $10,000 you hold in it.

You never receive a bill. The fund takes its fee from its own assets, a little at a time, so it shows up as a slightly lower value than the fund would otherwise have. That is exactly why it is easy to ignore.

Two things make it bigger than it looks:

• It is a share of everything you hold, not of your gain. If $10,000 earns 7% in a year, a 1% cost does not take 1% of the $700 gain — it takes 1% of the whole $10,700, which is $107, about 15% of that year’s gain.
• It is charged every year, rain or shine. In a year when the fund falls, the cost is still taken.

Index funds, which copy an index instead of paying people to choose, usually have lower expense ratios than actively managed funds. The exact figure is on the fund’s own page.

The other costs

The expense ratio is not the only cost. Most of the others are paid once, when you act, rather than every year:

• Commissions. Your broker may charge for each order, as a fixed amount or a percentage. A fixed $3 commission is 3% of a $100 purchase, but 0.3% of a $1,000 one: many small orders cost more than a few large ones.
• Currency conversion. US shares and ETFs are priced in dollars. Converting manats into dollars, and back again later, usually happens at a rate slightly worse than the market rate, or with a fee. If each conversion costs 0.5%, going in and coming out costs about 1%.
• The spread. At any moment the price you can buy at is a little higher than the price you can sell at. The gap is small for heavily traded funds and wider for thinly traded ones.
• Account fees. Some accounts charge a fixed monthly or yearly fee. Like a fixed commission, it weighs most on a small account.

Tax on gains and dividends is a cost too; it depends on where you live and is covered in the path Your first portfolio, from Azerbaijan.

Small percentages, long years

The reason a fraction of a percent matters is compounding. Growth builds on earlier growth — and a cost works the same way in reverse. Every dollar taken out this year is a dollar that will not grow next year, or in any year after.

Look at how the gap grows: $1,685 between the two funds after 10 years, $6,280 after 20, $17,564 after 30. The yearly percentages never changed. What changed is the balance they are taken from, and the years of growth each removed dollar has lost.

The figure uses the same assumptions. Set the annual fee to 1% and the years to 30, and the gap reads $19,815 — the cost against no fees at all. Then move the fee down to 0.1% and watch the two lines draw together.

Where to look

For a fund, the expense ratio is printed on the fund’s page and in its documents, usually near the top. For your broker, the commissions, conversion terms and account fees are in its published list of charges. Adding them up once, for the way you actually invest — how often, in what amounts, in which currency — gives you the true cost of your return.

In short

Every investment has costs: a fund’s yearly expense ratio, commissions on each order, currency conversion, the spread and account fees. A yearly cost is a percentage of everything you hold, and it compounds against you. In our illustration, the difference between 0.1% and 1.0% a year turned the same $10,000 into $73,872 or $56,308 after 30 years. Small numbers, long years, large difference.