Disclosure: The information provided in this article is for research purposes only and should not be construed as investment advice. This work was written to the best of my knowledge and belief and may contain errors. Every investment decision should be based on individual circumstances and consultation with a professional financial advisor. The author and the publisher of this article are not responsible for any investment decisions made based on the content of this article. Investing is risky!
The following analysis is based on publicly available data collected in September 2023 using automated scrapping and web data collection algorithms. It is assumed that the reader is familiar with the concept of Exchange-traded funds (ETFs), as this article has only the intend to analyze the annual performance of the ETFs over the last 5 years.
Exchange-traded funds (ETFs) have become a cornerstone of modern investment strategies. An ETF is a type of investment fund that is traded on stock exchanges, much like individual stocks. These funds can own a variety of financial assets such as stocks, bonds, currencies, and even commodities like gold bars. The assets and their weightings within each ETF are typically disclosed on the issuer’s website, either daily or quarterly. One of the primary advantages of ETFs is the diversification they offer, often comparable to mutual funds but with the added benefit of being traded like a stock on exchanges.
The concept of ETFs isn’t new. Their origins can be traced back to 1989 with the introduction of Index Participation Shares, which were a proxy for the S&P 500 and traded on the American Stock Exchange and the Philadelphia Stock Exchange. However, these were short-lived due to regulatory challenges. The real breakthrough came in 1993 with the launch of Standard & Poor’s Depositary Receipts (SPDRs), commonly known as “Spiders”, which quickly became the world’s largest ETF. Over the years, the popularity and variety of ETFs have grown exponentially, with offerings that track specific sectors, countries, or investment strategies.
Today, ETFs play a crucial role in global financial markets, offering investors a flexible and efficient way to diversify their portfolios, hedge risks, and gain exposure to various asset classes and market segments. Therefore, this article aims to analyze the risk and return performance of ETFs as of 2023, drawing insights from the last five years of historical data. Through this examination, the goal of this article is to provide a comprehensive understanding of how ETFs have fared in recent times.
I) Return-to-risk analysis
Let’s begin with the analysis of ETFs from all asset classes. For this analysis, we will consider only ETFs that are older than 5 years. In my dataset, I have 1,373 different ETFs to consider. Of those, 916 are Equity, 349 are Bonds, 64 are Commodities (i.e., ETC), 40 are Precious Metals, and 14 are Money Market ETFs. The full Excel sheet can be downloaded here:
Equity ETFs contain stocks or equities and typically track a specific stock index, such as the S&P 500, NASDAQ 100, or MSCI World. Bond ETFs invest in bonds or other debt securities issued by companies or governments. They offer investors a way to gain exposure to the bond market without purchasing individual bonds. Similarly, commodity ETFs provide exposure to commodities, including physical goods like gold, oil, agricultural products, and other raw materials. These ETFs allow investors to gain exposure to commodity prices without buying or storing the actual commodities. Precious metals ETFs are a sub-class of commodity ETFs that focus exclusively on precious metals, as the name suggests. Lastly, money market ETFs aim to give investors exposure to short-term, high-quality debt instruments, similar to traditional money market mutual funds. These instruments often include Treasury bills, commercial paper, certificates of deposit, and other short-term debt securities.
In this analysis, we assess “risk” based on the mean annual volatility of stock market prices over a 5-year period and “reward” based on the mean annual return over the same period. The following chart displays the return-to-risk ratio distribution for all 1,373 ETFs, categorized by ETF asset class.
All charts in this article are interactive. Utilizing the buttons located in the top right corner, users can zoom in/out, pan, or reset the view. Additionally, the legend is clickable, allowing users to toggle the visibility of the underlying ETF asset class. Hovering over a data point will reveal a tooltip text that provides the ETF’s underlying index name and its 15-character-long ISIN (International Security Identification Number) identifier.
Fig.1: Overall comparison of the return-to-risk ratio of 5 classes of ETFs
In this plot, the lines represent the results of a linear regression analysis, the purpose of which is to divide each ETF asset class group into two sub-groups. This should assists the reader in distinguishing between potential out- and under-performers. Additionally, the return-to-risk ratio of the most popular indices, namely MSCI World, S&P 500, and NASDAQ 100, are included in the plot as references. Over the past 5 years, the MSCI World has averaged an annual return of 13.6% with a mean volatility of 18.6%, the S&P 500 has returned in average 16.5% at 21% volatility, and the NASDAQ 100 has achieved 24.5% at 29.7% mean volatility. All three indices are located approximately at the Pareto front between the risk and reward.
The two predominant groups are the Bond and Equity ETFs. It’s evident that, in general, Equity ETFs have outperformed Bond ETFs, delivering annual profits over the past 5 years that surpass the average inflation in many developed countries. However, as the saying goes, there’s no free lunch on the stock exchange. High returns often come with high risks. Consequently, Equity ETFs exhibit significantly greater annual volatility compared to Bond ETFs. It’s clear that higher annual returns are often accompanied by increased risk. Yet, there are instances where an ETF might yield low returns while still being subject to high volatility. However, it appears there are no ETFs offering high returns with low volatility, as this area is behind the Pareto front.
Various investors have different investment objectives. For instance, young professionals often aim to accumulate wealth over their lifetime by allocating a portion of their salary to ETF investments, hoping to leverage compound growth for their retirement. Typically, they don’t anticipate needing these savings in the immediate future and can tolerate higher asset volatility. Such investors should opt for highly diversified ETFs that offer the maximum return for each unit of volatility. Conversely, another group of investors primarily seeks to shield their wealth from inflation without necessarily chasing high returns. They gravitate towards ETFs that have the lowest volatility relative to their return, aiming for returns that approximate the average annual inflation rate.
Therefore, following this considerations we want to define the quality metrics of the ETFs as follows:
\text{Score}=\frac{\text{Mean annual return}}{\text{Mean annual volatility}}
This is basically the return-to-risk ratio of an asset. This means that we appreciate ETFs that return the highest possible profit per volatility. The following plot shows the Top 100 ETFs with the best return-to-risk ratio over the last 5 years.
Fig.2: Top 100 ETFs according to the defined score value
II) Return-to-risk analysis of Equity ETFs
Now, let’s focus on equity ETFs, which is the most popular ETF asset type among the majority of investors . The advantage of owning equity ETFs is that the investor becomes a partial owner of the equities allocated within the specific exchange index that the given equity ETF tracks. Therefore, in my humble opinion, if one wishes to build wealth through compound growth during their professional life time, there’s one primary route: accumulating equity through investing into equity ETFs.
In the following plot, the return-to-risk is shown for equity ETFs only. In addition to the mean annual volatility and return, there’s another significant metric to consider: the number of stock positions a specific ETF holds. The larger the number of share positions inside the ETF “bucket,” the higher the diversification and the lower the risk, especially when the underlying index spans across several industry sectors, countries, or perhaps even continents. Therefore, in the following plot, the data is grouped by the number of positions within the particular ETF.
Fig.3: Return-to-risk distribution of equity ETFs
Now, we aim to value the selected equity ETFs using the same approach as in the previous section, employing our score formula, which essentially represents the return-to-risk ratio. From each group depicted in Fig. 3, we select the top 20 equity ETFs based on the highest return-to-risk ratio. Consequently, the following plot displays the top 100 equity ETFs from each position size class, ranked by their highest score value.
Fig.4: Top 100 equity ETFs
As of now, all equity ETFs have achieved an average annual return of 10.25% with an annual volatility of 18.55%. These reference values are marked as a black cross in the plot. Consequently, any ETF with an annual return below 10.25% can be, strictly speaking, considered as an under-performer, while an ETF with an annual volatility higher than 18.55% is considered riskier than the average performing ETF. Therefore, ETFs in the top-left quadrant relative to the reference cross might be of greatest interest. Among highly diversified ETFs with over 3,000 assets, we observe the dividend-distributing “Vanguard FTSE All-World UCITS” ETF (IE00B3RBWM25) which holds 3,677 assets. It exceeds the reference annual return and maintains a smaller annual volatility than the reference value. The one of the oldest and (from the point of view of invested capital) one of the largest dividend-accumulating “iShares Core MSCI World UCITS” ETF (IE00B4L5Y983), with 1,515 assets, averages a 13.69% mean annual return, surpassing also the reference value. However, its annual volatility (18.57% p.a.) aligns closely with the reference volatility. In the next group with 504 assets, we also have the long-standing “iShares Core S&P 500 UCITS” ETF (IE00B5BMR087) which tracks the US-based “S&P 500” index. Its average annual return over the past five years stands at a stunning 16.40%, however with a much higher annual volatility of 20.99%. It appears that ETFs with a larger number of assets tend to be less susceptible to annual volatility, though their annual returns might be somewhat diminished.
In this plot, it’s evident that there isn’t a singular approach to selecting ETFs for one’s portfolio. Some investors believe it’s vital to include all companies in their ETFs that are publicly traded on international stock exchanges, aiming for maximum diversification and hoping to capitalize on the returns of the “total public equity market”. Others typically choose one core ETF that spans more than 1,500 equity assets, allocating the majority of their funds to it. They then usually distribute the remaining funds among riskier but potentially higher return ETFs, treating them as smaller “satellite” positions in their portfolio. There’s no definitive right or wrong approach, as it all hinges on an individual’s investment objectives and the amount of risk someone is willing to accept. Nonetheless, in my humble opinion, it’s crucial to select ETFs with high return-to-risk ratios and commit to them for as long as feasible to compound his wealth effectively.
III) Dividend yield
Last but not least, we should also have a look on the dividend yield the considered ETFs have returned annually over the last 5 years. In the datasheet, we have 571 ETFs that distribute the collected dividends from the assets to their owner’s bank account. These dividends are paid out to their bank accounts either quarterly, semi-annually, or annually. Of these 571 ETFs, 211 are bond ETFs, 355 are equity ETFs, and 5 are Money Market ETFs. The remaining 802 ETFs accumulate the received dividends, meaning they automatically reinvest them for the client, thereby boosting the annual return even further.
In this final section, we will focus on all ETFs that distribute the dividends directly to their clients. We aim to analyze the mean annual dividend yield and its volatility over the past 5 years. In the following plot, the mean annual dividend yield from the last 5 years is plotted against its volatility. The black reference cross represents the mean values for all 571 distributing ETFs, which currently (as of September 2023) stand at a dividend yield of 2.14% p.a. and a volatility of 0.57% with respect to the past 5 years historic data. However, we can observe that the overall return-to-risk ratio is considerably better compared to the ETF stock market price returns discussed in earlier sections. Nonetheless, a typical dividend yield around 2% appears to be normal in 2023.
Fig.5: Dividend yield of distributing ETFs
IV) Conclusion
Exchange-traded funds are here to stay. They offer investors access to diverse market segments and asset classes, ensuring excellent diversification. In the initial section, we analyzed the performance of ETFs across various asset classes: Commodities, Precious Metals, Money Market, Bonds, and Equity ETFs. This analysis revealed that, compared to bonds, equity ETFs typically yield a higher average annual return of about 10% p.a. However, the mean annual volatility also rises to 19% p.a., based on historical data from the past 5 years. It’s crucial to note that this article does not serve as investment advice or guidance. Instead, its purpose is to provide a comprehensive overview over the current state of the market, while offering deep insights into the ETF market as of September 2023. Ultimately, the responsibility lies with investors to make informed decisions and select the most suitable ETFs, balancing the best return-to-risk ratio with acceptable annual return volatility risk levels.
As we move forward, I remain committed to closely monitoring and analyzing the ever-evolving ETF market. I will consistently share my insights, findings, and observations right here on this blog. For those passionate about investing and keen on staying updated with the latest trends and analyses in the world of ETFs, I encourage you to keep checking back and stay engaged with my upcoming posts.
