10-15% Return Potential For Index Funds And Exchange-Traded Funds

The return potential for index funds and exchange traded funds is at least 10-15% and returns of 20% or better are possible, especially over shorter periods of time (5 years or less).

Today we’ll look at some historical returns of the S&P 500 as well as a small investigation I did comparing the performance of sector specific ETFs.

To compare these returns to other types of investments, check out these articles:

• Return potential for real estate
• Return potential for bonds
• Return potential for mutual funds
• Return potential for business
• Return potential for collectibles
• Return potential for precious metals

What Is An Index Fund?

An index fund is a type of mutual fund. It pools together investors’ money to purchase a wide variety of stocks that is intended to provide broad market exposure.

For investors like us, it’s basically a cheap way to buy stocks in a wide variety of companies to reasonably diversify. This allows your investment’s returns to be dependent on the entire market, rather than just a few companies.

What Is An Exchange-Traded Fund?

An exchange-traded fund (ETF) is also a type of mutual fund. They also pool people’s money to purchase stock in a wide variety of companies. The difference is that ETFs often have a sort of theme.

The underlying assets in an ETF might all be related to a specific industry, like the Technology Select Sector SPDR Fund which specializes in the Tech industry. Or they might have only mid cap companies (iShares Core S&P Mid-Cap ETF) or companies from a specific country (iShares MSCI Germany ETF).

Historical Returns Of The S&P 500

I like to do my analyses with real numbers, and the S&P 500 is often considered the mother of all index funds. I’ve done one analysis of the S&P 500 using its historical stock prices, but since those stock prices didn’t take dividend returns into account, today I’m going to use the numbers provided by moneychimps S&P 500 compound annual growth rate (CAGR) calculator.

Since my previous analysis, gave us information about which periods of time had the greatest returns, I’ll leverage that information during this analysis.

Slight data mismatches

Unfortunately the moneychimp calculator only had return values starting and ending on January 1st. The 5 year best found from my previous analysis started May 1932 and ended in May 1937, so the calculated CAGR from that 5 year period isn’t representative of the actual 5 year best, unfortunately.

When I went back and looked, the S&P from January 1932 to May 1932 dropped by more than 30%. And it also dropped again at the end of 1937. So what was previously a 5 year best CAGR of more than 30%, now looks like a 23% CAGR.

This is a bit disappointing since the data didn’t always support the time period I wanted to look at. But if nothing else, it goes to show the importance of when you enter and exit the market.

If you had entered the market in January 1, 1932 and exited January 1, 1937 you would have realized returns of 23% each year. But if you entered a few months later on May 1, 1932 and exited May 1, 1937 you would have realized returns of over 30%.

Discussing the historical returns

We see some numbers as high as 22% and numbers as low as 6%. There are some important points to make when looking at this data.

First is that when it comes to index funds, your returns are based primarily on when you buy and when you sell. There’s not much special analysis for an index fund investor to do. You don’t need to research companies and gain any specialized knowledge of the market. You just buy and kind of hope that the market is increasing as long as you own that fund.

This can be seen clearly when we compare the last X years with the best X year periods. Compare the return of the last 5 years, 11.62%, with the best 5 year return, 22.78%. If you were born after 1932, and most of us were, then you wouldn’t have ever had the chance to realize the 22.78% 5 year return.

Also consider that the best 10, 15, 20 and 30 year returns all used the returns from 1990 to 1998. If you were investing during those years, you were basically guaranteed to have great returns.

So there’s a definite element of luck involved. When you are born and when you are investing plays a significant role in your return potential for index funds.

The second point I wanted to make is that you can realize better returns over shorter periods of time. Those 22.78% returns we saw during our 5 year best are not repeatable for 10 and 20 years. The longer you invest, the lower your return potential gets, but also the more predictable your returns get.

Return potential (and expected return)

I would argue that your return potential is dependent on the length of time you will be investing. When you look at a return potential over 5 years, you can safely claim that returns of 20% are possible if you’re investing at the right time.

Likewise, your return potential over 10, 15 and 20 years is at least 15% (if you’re investing at the right time).

The problem is we’re stuck investing in 2020 and beyond. We don’t really know if we’re going to see those kind of returns over the next 20 or 30 years. The potential is there, we’ve seen it before, but that doesn’t mean we can expect those numbers.

When we talk about the expectation for the next 20 or 30 years, we will start to look at the long term averages. The all time CAGR for the S&P 500 is about 9%, and the returns over the last 30 years were about 10%.

If I’m thinking about my returns over the next 30 years, I’m much more likely to look at the 9-10% returns as a reasonable expectation.

Historical Returns Of Various ETFs

A few months ago, I did a comparison of ETFs in different sectors. I never published an article about it, but you can look at the google spreadsheet I created during the investigation.

The sectors I looked at were:

• Technology
• Real Estate
• Financials
• Healthcare
• Materials
• Utilities
• Consumer Discretionary
• Consumer Staples
• Energy
• Industrials
• Telecommunications

These sector ETFs are more recent, with very few of them having more than 30 years worth of data, and several of them having less than 10 years of data. So take these numbers for what they are: a look at various sectors over the past 10-30 years.

The comparison looked at the top 9-10 ETFs in each sector based on their market share (this just means the ones that manage the most money). Then I looked at the worst, average and best returns of each ETF over the longest possible time period (sometimes 5 years, sometimes 10 or 15 or 20 or 30 years).

At the end I took the average of all 9-10 ETFs in each sector for each of the worst, average and best to come up with a weird kind of guesstimate of the relative performance of each industry. Not a super scientific approach, but it at least shows how the performance of a fund can vary if you specialize in a particular sector.

Here were the results

I don’t want to dive too deeply into this data. I only put it here to point out that while the returns of a traditional index fund like the S&P 500 may be limited primarily by when you buy and sell, you can almost certainly beat the S&P 500 with by correctly picking more focused funds.

As you can see here, both Technology and Consumer Discretionary ETFs have performed very well in recent years. Even the Healthcare sector has had great returns.

Many studies have shown that it’s very difficult to beat the market (basically meaning the S&P 500) over time, but we can show that it is at least possible.

With the right ETF picks, you could definitely hit 15% returns over long periods of time.

Taxation

OK we’ve seen that index funds and ETFs are capable of producing returns of 10-20% over periods as long as 20 years. But that’s all before taxes. What happens after these gains are taxed?

Dividend taxes

We have two types of returns in the stock market, gains and dividends. And they are each potentially taxed differently.

Qualified dividends are taxed at the same rate as long term capital gains, and unqualified dividends are taxed as regular income.

If you only have qualified dividends then the most you can be taxed on those is 20%. If you’re not a super wealthy individual then these rates will likely be lower for you.

Gains taxes

When you sell any stocks you own, you will also own capital gains taxes on those stocks. That the amount of value the stocks gained while you owned them.

If you bought shares for $10,000 and then years later sold those same shares for $20,000, you would have to pay capital gains taxes on the $10,000 in value your shares gained.

As long as you hold your stocks for at least one year, you’ll never owe more than 20% in taxes on your capital gains.

Effect on returns

The return numbers we’ve looked at so far did not take taxes into consideration. So somewhere between 0 and 20 percent of those return numbers will be eaten away by taxes.

This can potentially take a 20% return down to, at worst, a 16% return.

Conclusion

The return potential for index funds and exchange-traded funds is 10-15% by my estimation, though with great decision making and some luck, you could see returns of 20% or better.

I count these investments among the best because they offer respectable returns and are almost completely passive. They don’t quite compete with the return potentials of real estate and business, but index funds and ETFs are tops among passive investments.

Happy investing.

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