Fees as Compounding Drag: The Long-Term Cost of Small Percentages

A 1% difference in fees does not feel significant. It is one dollar out of a hundred. In the context of a $10,000 investment, that is $100 per year. Noticeable, perhaps, but hardly decisive.

Over twenty or thirty years, that same 1% becomes something else entirely. Compounding works on everything: returns, contributions, and costs. The fee that seems marginal in year one becomes a substantial portion of your potential wealth by year twenty-five.

This article explains how fees compound over time, what the main fee types are, and how to evaluate costs in the context of long-term outcomes. The goal is not to optimise every last basis point, but to understand what you are paying and why it matters.

This is general educational information, not personal financial advice.

The Mathematics of Fee Drag#

Fees do not simply subtract from returns. They subtract from the base on which future returns are calculated.

Consider two investors, each starting with $100,000 and earning 7% annually before fees. One pays 0.5% in fees; the other pays 1.5%.

After 30 years:

The 1% fee difference has cost $142,155 over three decades. That is not 1% of the original investment. It is 142% of the original investment, lost to fees.^¹

This happens because fees compound in reverse. Each year, the higher-fee investor has a smaller base. The following year's returns are calculated on that smaller base. Over time, the gap widens exponentially.

The effect is more pronounced the longer the time horizon. Over 10 years, the difference is noticeable. Over 40 years, it is transformational.

Types of Fees#

Fees come in many forms. Some are obvious; others are embedded in structures that make them harder to see.

Management Expense Ratio (MER)#

The MER is the annual cost of running a fund, expressed as a percentage of assets. It includes management fees, administration costs, and most operating expenses. It is deducted automatically from the fund's returns; you do not pay it directly.

An MER of 0.20% means you pay $20 annually for every $10,000 invested. An MER of 1.50% means you pay $150.

MERs vary widely:

• Passive index ETFs: typically 0.03% to 0.50%
• Active managed funds: typically 0.50% to 1.50%+
• Some specialty or alternative funds: 2.00%+

Lower MERs are not inherently "better" because what you pay for differs (passive tracking vs active management). But all else being equal, lower fees leave more returns for the investor.

Brokerage#

Brokerage is the fee paid for each transaction. Unlike MER, which is ongoing, brokerage is incurred only when you buy or sell.

For infrequent traders, brokerage is a minor cost. For frequent traders, it can become substantial. An investor making 50 trades per year at $10 per trade pays $500 annually in brokerage alone, regardless of portfolio size.

Brokerage affects behaviour. High per-trade costs discourage small, regular investments (dollar-cost averaging becomes expensive). Low or zero brokerage can encourage excessive trading, which has its own costs.

Buy/Sell Spread#

The buy/sell spread is the difference between the price at which you can purchase and the price at which you can sell. For funds, this is often applied as a percentage added or subtracted from the unit price.

A 0.10% buy/sell spread means you pay 0.10% above NAV when buying and receive 0.10% below NAV when selling. The round-trip cost is 0.20%.

Spreads compensate the fund for transaction costs when investors enter or exit. They protect existing investors from bearing the cost of other investors' activity. But they are still a cost to you.

Platform Fees#

Some investment platforms charge account-keeping fees, typically a flat annual fee or a percentage of assets held. These fees cover the platform's administration, custody, and reporting services.

Platform fees are additional to MER. An investor paying a 0.30% MER plus a 0.20% platform fee is paying 0.50% in total ongoing costs.

For small portfolios, flat-fee platforms may be more cost-effective. For large portfolios, percentage-based fees can become significant.

Performance Fees#

Some active funds charge performance fees: additional payments triggered when returns exceed a benchmark or hurdle rate. These fees are typically 10-20% of outperformance.

Performance fees align manager incentives with investor outcomes, in theory. In practice, they can create complex incentive structures and make total costs difficult to predict. A fund with a 1.00% base fee plus a 20% performance fee can cost significantly more than 1.00% in strong years.

Visualising the Long-Run Impact#

Abstract percentages are hard to feel. Concrete numbers are easier.

The following table shows how a $50,000 investment grows over various time periods at 7% annual return, under different fee levels.

Over 30 years, the difference between 0.25% and 1.75% fees is $136,012. That is 272% of the original investment.

These numbers assume consistent returns, which do not occur in reality. But the principle holds: fees subtract from every year's base, and the effect compounds.

Fees in Context#

Fee awareness can become fee obsession. This is counterproductive.

A 0.50% fund that matches your investment objectives is better than a 0.10% fund that does not. An actively managed fund with a 1.00% fee that provides genuine diversification benefits may be appropriate for some portfolios, even if a cheaper passive alternative exists.

The question is not "what is the lowest fee?" but "what am I paying, and what am I getting for it?"

What Higher Fees Might Buy#

• Active management and security selection
• Access to asset classes or markets not available in passive products
• Tactical allocation and risk management
• Specialised expertise in niche areas

Whether these justify higher fees depends on execution. Research consistently shows that most active managers underperform their benchmarks after fees over long periods.^² But some do add value, and some investors have specific needs that passive products do not serve.

What Higher Fees Do Not Buy#

• Higher expected returns (fees are a drag, not a predictor of performance)
• Lower risk (fee level and risk are not correlated)
• Better outcomes automatically (expensive funds can and do underperform)

Paying more does not mean getting more. It means needing more outperformance just to break even with cheaper alternatives.

Comparing Fees in Primary Documents#

Fee information is disclosed in product documents, but it is not always presented in comparable formats.

Where to Find Fee Information#

• Product Disclosure Statement (PDS). The primary legal document for managed funds and ETFs. Fees are disclosed in a standardised "Fees and costs summary" section.^³
• Additional information documents. Some funds provide supplementary fee details beyond the PDS summary.
• Broker fee schedules. Brokerage and platform fees are disclosed on broker websites and in account terms.

What to Compare#

When comparing funds:

• Total management costs (MER or equivalent)
• Buy/sell spreads
• Performance fees, if any
• Any other costs disclosed in the PDS

When comparing platforms:

• Brokerage per trade
• Account-keeping or platform fees
• FX conversion costs for international investments

Watch for Inconsistent Terminology#

Different providers use different terms for similar costs. "Management fee," "management cost," "MER," and "total cost" are not always interchangeable. Read the definitions in the PDS to understand what is included.

The Fee Comparison That Matters#

The most important comparison is not between fund A and fund B. It is between your total costs now and what they will become over time.

A portfolio with a weighted average cost of 0.50% is not 0.50% cheaper than one with 1.00%. Over 30 years, it is potentially worth tens or hundreds of thousands of dollars more.

Reducing fees by 0.25% is not exciting. It does not feel like a win. But it may be worth more than any individual investment decision you make.

This is the uncomfortable truth about fees: the gains from reducing them are invisible. You do not see the money you did not lose. You only see the slightly higher balance, years later, and by then it is hard to remember what caused it.

Summary#

Fees compound in reverse, subtracting from the base on which future returns are calculated. A 1% difference in annual fees can cost hundreds of thousands of dollars over a multi-decade investing horizon. Key fee types include MER (ongoing fund costs), brokerage (per-trade costs), buy/sell spreads (entry and exit costs), platform fees (account administration), and performance fees (conditional payments to active managers). Lower fees do not guarantee better outcomes, and higher fees can sometimes buy genuine value, but paying more requires that the investment outperform cheaper alternatives by the fee difference just to break even. Fee information is disclosed in PDSs and broker fee schedules; comparing total costs across products requires reading these documents carefully. The goal is not to minimise every basis point, but to understand what you pay and whether it is justified by what you receive.

Sources#

1. Vanguard. (2023). The case for low-cost index fund investing. https://corporate.vanguard.com/content/corporatesite/us/en/corp/articles/case-for-low-cost-index-fund-investing.html

1. S&P Dow Jones Indices. (2024). SPIVA Australia Scorecard. https://www.spglobal.com/spdji/en/research-insights/spiva/

1. ASIC. (2024). Fees and costs disclosure. https://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-97-disclosing-fees-and-costs-in-pdss-and-periodic-statements/