ETFs are a great way to invest your money. They are generally much safer than regular stocks since you invest in a portfolio of different stocks or other assets. You can make money through ETFs by trading them or waiting for a long-term increase in their price, but can you also earn compound interest?
ETFs don’t earn compound interest. However, compounded growth is possible. It can happen either through dividends or through value appreciation of the fund’s assets. You can reinvest the dividends into the fund resulting in a compounded profit.
This article will explain precisely how compounding works with ETFs and the types of ETFs that compounding works best with.
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How Does ETF Compounding Work?
ETFs and other securities listed on the exchanges can’t earn you interest, at least not in the usual sense. However, what stocks can do is pay out dividends, and it’s then up to you whether you want to keep the money or reinvest it into the fund, which can then lead to compounded profit.
Most managed funds, including ETFs, constantly reinvest earnings back into the fund. There are three main ways that compounding can be related to ETFs:
Dividend Yield Compounding
The most popular way your profits can compound with ETFs is through dividends. Dividends are distributed either monthly or quarterly, depending on the fund. To achieve compounded growth, you need to reinvest the gained dividends back into the fund.
Most ETFs offer the option of automatically reinvesting all of your dividends or capital gains. Otherwise, you can also do it manually. As you keep reinvesting your profits, the value of the assets you hold will increase over time and bring you compounded growth.
Constantly reinvesting in passive ETFs is thus a widespread investment strategy that is almost risk-free yet can be decently profitable in the long run.
Value Appreciation
Even if you don’t get any dividends, your profits can still be compounded if the held assets’ value increases over time. For example, if you invest $10,000 in some shares, and the value of the shares increases to $11,000 within a year, you will experience a 10% gain.
Now, if there is a 10% gain the following year as well, you won’t simply profit another $1,000. Instead, a 10% gain on $11,000 will equal $12,100.
If the value of the shares keeps increasing over a long period, your profits will exponentially increase thanks to compounding growth.
Capital Reinvestment
Once a year (usually each December), ETFs distribute capital gains. Keep in mind that for some ETFs, such as index funds, capital gains can be rare.
Regardless, once the capital gains are in your account, you can choose to reinvest them into the fund and compound your profit. This whole process works similarly to dividends and can sometimes be done automatically by the fund.
Why Is Compounding So Powerful?
Compounding is considered the most potent tool in investing by many traders. Many famous investors have made their fortune through compounding, including perhaps the most famous one – Warren Buffet.
But, why exactly is compounding so powerful?
Compounding is powerful because it doesn’t require a substantial initial investment to bring in massive profits. Instead, continual re-investment over a more extended period, ideally more than five years, will sometimes double or even triple your initial investment.
Of course, finding assets that are safe to invest in long-term isn’t easy. ETFs are certainly up there when it comes to risk management and long-term potential. However, not all ETFs are built the same.
Best ETFs To Invest in for Compounded Growth
While ETFs, in general, are an excellent investment for compounded returns, not all of them
would work for this type of investment strategy. ETFs can differ in terms of the assets that they hold and their management style.
The best type of ETFs for achieving compound growth are passive ETFs.
Passive ETFs
In terms of management style, passive ETFs are considered to be the best for compounded profit. Passive ETFs closely follow indexes and do very little when it comes to management.
Thus, they are low in management costs and are excellent for long-term compounding growth since they deal with stable indexes that generally increase over time.
Passive ETFs are the complete opposite of active ETFs, which instead try to beat the market with the constant trading of assets. However, even the most skilled traders are rarely profitable with that strategy.
There are many types of passive ETFs out there. Here are some of the best for compounded profit:
Index ETFs
An index ETF is designed to replicate a designated index like the S&P 500, Dow Jones, or another. They are arguably the most popular type of ETF, as they give investors access to diversified, safe, and future-proof trading strategies.
No investment comes without risk, but the stock market has been on a consistent rise for over 50 years. Investing in an index of the best companies in the world will give you an excellent chance of earning some profit each year, or every six months, depending on the ETF.
You can then reinvest that profit back into the market in either the same or a different index for more diversification.
Dividend ETFs
Dividend ETFs strictly seek out companies that pay out dividends. These ETFs are passively managed and constantly analyze the dividend index to find the companies that pay the highest dividends to their shareholders.
The compounding growth with dividend ETFs is prolonged yet secure. If you can manage to get the yearly dividend earnings up to $100, you can then reinvest it into the fund and watch how your profits increase over a few years.
You can invest any amount you make, even if it’s 5$ or less, but the impact won’t be as significant.
Keep in mind that dividends are usually meager, and just a fraction of the amount you invested. That means that you will need to invest a substantial amount to make your dividend earnings significant and thus your compounded returns significant.
Another positive of dividend ETFs is that companies who give out dividends are generally highly profitable and high-growth companies. Thus, investing in them is pretty safe and can be very profitable if you are patient.
Why Invest in ETFs Over Individual Stocks?
Both buying individual stocks and ETFs can be suitable for compounding profit. None is better than the other, but here are a few reasons why you might want to choose ETFs:
- You Aren’t Too Familiar With the Market or Sector. If you are a novice investor or are simply unfamiliar with a particular sector and its companies, you could use the professional management that comes with ETFs.
- Stock Returns in a Sector Have a Narrow Dispersion Around the Mean. If stocks in a particular sector yield very similar returns, you are better off investing in an ETF in that sector rather than picking individual stocks.
- You Want To Play It Safe(er). While nothing is guaranteed in the stock market, ETFs are generally considered safer than buying individual stocks.
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Conclusion
ETFs are an excellent investment and can earn you compounding profits. Compounding with ETFs comes through capital income or income from dividends reinvested into the fund.
Not all ETFs work well for compounding. Passive ETFs are the best in this regard since compounding is a long-term process. Passive ETFs provide a stable and low-risk investment that should be excellent for steady income over a long period.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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