Investopedia describes Compounded Annual Growth Return (CAGR) as, “The rate of return, usually expressed as a percentage that represents the cumulative effect that a series of gains or losses have on an original amount of capital over a period of time. Compound returns are usually expressed in annual terms, meaning that the percentage number that is reported represents the annualized rate at which capital has compounded over time. When expressed in annual terms, a compound return can be referred to as a “compound annual growth rate (CAGR)”.
Problems with the CAGR
In other words, the CAGR is just a way of smoothing out potentially volatile yearly returns, but unfortunately, it can give the illusion that there is a steady growth rate even when the value of the underlying investment annual returns vary significantly. This volatility, or investment risk, is important to consider when making investment decisions and it’s something QiT carefully scrutinizes.
The CAGR is a term best defined by example. Let’s say a trader invested $25,000 in Portfolio A on January 1, 2007, and 6 years later it has grown to $50,000. The CAGR is 12.25%, not too bad. Remember CAGR is smoothing out the progress of the investment over a period of time, providing a clearer picture of the annual return. However, although the investment started at $25,000, and ended with $50,000, its growth in any one year may have been quite a bit higher or even negative. Consequently, the CAGR may give the “false” impression that the investment has produced a stable return throughout its life, even if the investment was extremely volatile, fluctuating a great deal from year to year.
To highlight the example take a look at what would have happened had the $25,000 investment been in the SPY (the S&P500 ETF) on January 1, 2007, instead of the fictitious Portfolio A. On January 1, 2007, the SPY opened at 124.57 so exactly 200 shares were bought. Let’s say six years later, on January 1, 2013, those 200 shares were sold at the open, 143.70. The CAGR works out to 2% and while 2% is not wonderful, at least it’s positive. What the CAGR does not describe is that by March 2009, the S&P had lost 57% of its value and the CAGR had fallen to a mind-boggling -23.73%. So, the CAGR has its limitations. It’s also important to remember it does not reflect investment risk.
How QiT uses the CAGR
The Compounded Annual Growth Return is where QiT starts portfolio building. We will not consider any algorithms that have a CAGR of less than 15% and most will have CAGRs well over 20%.
Note, Amibroker calls this metric CAR.