ETF Returns: Key Metrics for Long-Term Growth

At Quantlake, our mission is to provide investors with simple and comprehensive financial data, enabling them to make informed and data-driven investment decisions that lead to long-term success.

When it comes to investing in ETFs (Exchange-Traded Funds), understanding the types of returns they generate, how to calculate return on investment (ROI), and how to determine the compound annual growth rate (CAGR) can empower you to make more data-driven decisions. At Quantlake, we are committed to simplifying these concepts for you, ensuring your path to long-term financial success is clear and informed.

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Types of Returns an ETF Can Generate

• Capital Gains: The profit made when selling ETF shares at a higher price than the purchase price. For example, if you buy ETF shares at $100 each and later sell them at $150 each, the $50 difference is your capital gain. Capital gains are realized only when you sell the investment.
• Dividends: Earnings distributed to shareholders from the profits of the companies within the ETF. These are typically paid quarterly and can be taken as cash or reinvested to buy more ETF shares.
• Interest Income: Returns from interest payments on bonds or other interest-bearing instruments within the ETF. This is common in bond ETFs that generate income from the interest paid by the bonds they hold.
• Appreciation: The increase in the ETF's value over time, reflecting the overall performance of the underlying assets. Appreciation refers to the rise in the market value of the ETF itself, regardless of whether you sell the shares or not. It represents unrealized gains.
• Reinvested Dividends: Dividends that are reinvested to purchase more shares of the ETF, potentially compounding returns over time. This reinvestment can lead to a higher total return as the additional shares also generate dividends and appreciate in value.
• Return of Capital: This is a distribution paid to investors that is not considered taxable income. It is essentially the return of a portion of the investor's original investment. It reduces the cost basis of the investment but does not impact the overall value of the ETF. For instance, if you initially invested $10,000 and received a $1,000 return of capital, your new cost basis would be $9,000.

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Calculating Return on Investment (ROI)

• ROI is a straightforward measure to understand how much profit you've made on an investment.
• ROI = (Current Value of Investment−Initial Value of Investment) / Initial Value of Investment x 100
• Example: You invested $10,000 in an ETF 20 years ago. Today, it's worth $50,000.
• ROI= (50,000−10,000) / 10,000 × 100 = 400%
• This means your investment has grown by 400% over the 20 years.

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Calculating Compound Annual Growth Rate (CAGR)

• CAGR provides the mean annual growth rate of an investment over a specified period of time longer than one year. It’s a useful measure because it smooths out the effects of volatility and gives a clearer picture of investment growth.
• CAGR = [(Current Value of Investment / Initial Value of Investment)^(1/Number of Years)] - 1
• Example: Using the same $10,000 investment over 20 years, now worth $50,000:
• CAGR= (50,000/10,000)^(1/20)−1=0.0838 or 8.38%
• This shows that your investment grew at an average annual rate of 8.38%.

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Evidence-Based Insights

Ibbotson Stocks, Bonds, Bills, and Inflation (SBBI) Classic Yearbook shows that compounding significantly contributes to wealth creation over extended periods. Fama and French demonstrated that diversification helps reduce risk and enhances returns over the long term. Furthermore, research by J.C. Bogle (2009) supports that passive investing strategies, typically implemented through ETFs, outperform most actively managed funds when considering the costs involved (which reduce your returns).

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Conclusion

Understanding the types of returns, calculating ROI, and determining CAGR are fundamental steps in evaluating the performance of your investments. At Quantlake, we believe that informed investors are successful investors.

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Happy Long-Term Investing from the Quantlake Team.