Index Funds: The Fee Compounds Too

Michael Whitman · Trading since 2017, full-time since 2020 · Reviewed 2026-09-06

An index fund holds every constituent of a stated index in the stated proportions, with no manager choosing what to own. That removes both the possibility of beating the index and most of the cost of trying, and the cost saved compounds exactly the way a return does.

How it works

A candlestick chart of the site's shared price history. The headline on the chart reads: A fund that buys the whole list instead of picking. — A fund that buys the whole list instead of picking. Illustrative chart - not real market data.

An index fund holds what the index holds. No analyst decides anything; the fund buys every constituent in the published proportions and adjusts when the index does.

A gently rising stretch of the long price series with an account equity curve beneath it. The headline on the chart reads: Nobody decides what it holds, which is why it is cheap. — Nobody decides what it holds, which is why it is cheap. Illustrative chart - not real market data.

Removing the decision removes the cost. No research team, no analysts, no manager, and very little trading — which is why the cheapest trackers charge a few hundredths of a per cent.

What the fee actually costs

A 72-bar candlestick section of the shared price history with an account curve shown with and without fees. The headline on the chart reads: Five basis points costs 1.5% of a thirty-year pot. — Five basis points costs 1.5% of a thirty-year pot. Illustrative chart - not real market data.

A basis point is one hundredth of a percentage point. At five of them, compounding the fee alone across thirty years removes 1.5% of the pot.

A flat, quiet stretch of the long price series with a slowly rising equity curve beneath it. The headline on the chart reads: And one and a half per cent costs 36.5% of it. — And one and a half per cent costs 36.5% of it. Illustrative chart - not real market data.

At one and a half per cent it removes 36.5%. Same period, same arithmetic — more than a third of the final amount, before any question of whether the manager added value.

A calmly advancing stretch of the long price series with a gradually rising equity curve beneath it. The headline on the chart reads: The fee compounds exactly the way the return does. — The fee compounds exactly the way the return does. Illustrative chart - not real market data.

That is why the annual figure is misleading. One and a half per cent sounds small against a market that might return seven; over thirty years the two compound against each other and the fee takes a share of every year’s growth, not just of the original sum.

The intermediate figures fill in the picture. Twenty basis points removes 5.8% of a thirty-year pot and seventy-five removes 20.2%. The relationship is close to linear at these levels, which makes the comparison between two funds straightforward: multiply the fee difference by roughly twenty-four to get the share of the final pot at stake.

What you are actually buying

A strongly rising stretch of the long price series with an account curve breaching its limit. The headline on the chart reads: Most indices weight by size, so the biggest dominate. — Most indices weight by size, so the biggest dominate. Illustrative chart - not real market data.

Almost every major index weights by market capitalisation. The largest company gets the largest holding, which means the fund automatically holds more of whatever has already risen.

A choppy, directionless stretch of the long price series. The headline on the chart reads: Which makes a broad fund less diversified than it sounds. — Which makes a broad fund less diversified than it sounds. Illustrative chart - not real market data.

Five hundred holdings is not five hundred equal bets. A capitalisation-weighted fund can have a third of its value in ten companies, so the diversification implied by the name overstates what is there.

A declining stretch of the long price series. The headline on the chart reads: Tracking error is the gap between the fund and the index. — Tracking error is the gap between the fund and the index. Illustrative chart - not real market data.

Tracking error is the gap between fund and index. It comes from fees, from cash held for redemptions, and from sampling where a fund holds a subset rather than everything — and it is worth checking alongside the headline fee.

In practice

A candlestick chart with a volume histogram beneath it, with the volume histogram emphasised. The headline on the chart reads: Participation decides how cheaply it can be traded. — Participation decides how cheaply it can be traded. Illustrative chart - not real market data.

Volume matters for the exchange-traded versions. A thinly traded tracker has a wide spread, which is a cost that never appears in the published fee.

A long-horizon candlestick view of the same price series. The headline on the chart reads: It is a decades instrument and behaves like one. — It is a decades instrument and behaves like one. Illustrative chart - not real market data.

The instrument is built for decades. Its advantages — low cost, no manager risk, no selection error — all accumulate slowly and are invisible over a year.

A candlestick series containing several opening gaps, with the largest opening gap marked. The headline on the chart reads: And it gaps with everything else, all at once. — And it gaps with everything else, all at once. Illustrative chart - not real market data.

It provides no protection in a fall. Holding everything means holding everything on the way down, and a gap affects the whole index at once.

A declining stretch of the long price series, with the entry price and the level at which a stop would trigger drawn as horizontal lines. The headline on the chart reads: A stop on a long-term holding is usually the wrong tool. — A stop on a long-term holding is usually the wrong tool. Illustrative chart - not real market data.

A stop sits awkwardly on a decades-long holding. The whole proposition is continuing to hold through declines, and an automatic exit contradicts it.

Every trade in it still costs a share of a bar. Illustrative chart - not real market data.

Trading it frequently defeats the point. Each round trip is 2% of a median bar’s range on this history, which is many times the annual fee of a cheap tracker.

One decision matters more than the fee and gets far less attention: which index. A fund tracking a domestic large-company index and one tracking a global all-cap index are different investments with the same structure, and the choice between them affects the outcome far more than five basis points either way.

The second-order questions follow from that. How many companies, weighted how, in which countries, and whether small companies are included at all. A cheap fund tracking the wrong index for your purpose is a worse outcome than an expensive one tracking the right one — which is the opposite of how the choice is usually presented, because the fee is the easy number to compare and the index is the one that decides what you own.

And the index itself is a set of rules somebody wrote. Inclusion criteria, rebalancing dates and weighting caps are all decisions made by a committee at an index provider — so “passive” describes your behaviour rather than the product’s.

What an index fund is not

It is not diversified by holding count. Weighting decides that.

It is not free. It is cheap, and the fee still compounds.

It is not safe. It falls with the market, in full.

And it is not a strategy. It is a low-cost way to own the market.

When it fails

A sideways, range-bound candlestick series. The headline on the chart reads: In a flat decade it delivers the flat decade. — In a flat decade it delivers the flat decade. Illustrative chart - not real market data.

It delivers the index, including when the index does nothing. A flat decade produces a flat decade minus the fee, and there is no mechanism in the product to improve on that.

The second failure is a concentrated index sold as broad. A fund holding thousands of companies with a third of its value in ten is a concentrated position with a reassuring name.

A third is buying several that overlap. Three broad funds frequently hold the same largest companies, which adds cost without adding diversification.

A fourth is comparing funds on fee alone. Tracking error and spread both matter and neither is in the headline number.

And a fifth is trading it. The advantage is entirely in holding cheaply for a long time.

The original data

Compounding the fee alone over thirty years: five basis points removes 1.5% of the pot, twenty removes 5.8%, seventy-five removes 20.2% and one hundred and fifty removes 36.5%. Across this site’s shared 576-bar history the same rates cost 0.11%, 0.46%, 1.70% and 3.37%. The figures are in research/series-measurements.json, produced by site/measure_series.py.

A 72-bar window of the shared price history, cut short at the decision bar. The headline on the chart reads: Down 20% and the plan said hold. Sell? — Down 20% and the plan said hold. Sell? Illustrative chart - not real market data.

Those figures contain no return assumption at all — they are the fee compounding against itself, so the real cost on a growing pot is larger still. The comparison worth running before choosing between two funds is the difference in fee multiplied by roughly twenty-four, which converts an annual percentage nobody can feel into the share of the final amount it represents. It is the highest-value minute available in the whole subject, and it only has to be spent once.

Exchange-traded fund investing is the wrapper and its extra costs. Mutual funds is the actively managed alternative. And passive income covers what these holdings are usually bought for.

What I actually do

The number that made me take fees seriously was not the annual one. It was seeing that the difference between five basis points and one and a half per cent is more than a third of the final pot, from a decision made once and never revisited.

— Michael Whitman

This page is educational, not financial advice. Test every idea on your own charts before risking money.