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MSF Student Co-Authors Paper in the Financial Analysts Journal with Professor Robert Whaley

Feb 24, 2021
Professor Whaley asked student Colby Pessina (MSF'20) to help with his latest research after getting to know each other through a course

By Katie Bahr

In the first few weeks of his Applied Investment and Management class, Professor Robert Whaley assigned a Monte Carlo simulation problem on levered and inverse exchange-traded funds (ETFs) to his Owen Master of Science in Finance students. The simulation uses past benchmark index performance to project thousands of possible future behaviors. For levered and inverse ETFs, the future behaviors always had the same eventual fate: collapse.

“It’s been clear to me for over a decade that something was amiss with these products,” Whaley sad. “I could see the problems mathematically, but it’s difficult to convey those particular issues to practitioners. I’d decided it was finally time to write about it, and I wanted to involve a student.”

Though the entire class conducted the simulation, Whaley chose Colby Pessina (MSF’20) to partner on the paper because of his interest in the policy implications and the big picture surrounding the assignment. Pessina had been interested in levered and inverse ETFs before, but after conducting the simulation, he began researching them and coming to Whaley with questions after class and during office hours.

“I’d heard of friends investing in these products hoping to make some sort of crazy return,” Pessina said. “I was trying to understand how they do what they say they’re going to do, and why’re they’re so controversial.”

Levered and inverse ETFs attempt to provide a given factor (e.g., 2x, 3x, -3x) of a benchmarked index’s daily return. Instead of holding securities directly, these products use futures and swaps to magnify the return of an index like the S&P 500. To consistently provide the ‘promised’ long or short exposure to the index, the products’ holdings must be rebalanced at the end of each day, and this daily rebalancing destabilizes the market. Pessina and Whaley shared the same concerns about the products and how little the investing community as a whole understands them.

“Let’s say you invest in a 2x levered ETF tracking the S&P 500, and, on the first day, the S&P 500 gains 5%. You’ve now made a 10% return in one day. The next day the S&P 500 loses 5%. You may expect your total 2-day return to be 0.5% (two times the two-day return of the index). But, in actuality, your return will be a negative 1%,” Pessina said. “You’re now left with less money than you began with. The fact that these products compound returns is what makes them so unpredictable and dangerous.”

Whaley specifically sought the Financial Analysts Journal for publication because of its large circulation and CFA readership. He had a clear vision for the statistical analysis and brought Pessina in to assemble background data and review drafts. Their resulting paper, published in January, demonstrates that regardless of factor or asset class, most levered and inverse ETFs can be expected to die, absent corporate actions such as reverse splits. Investors who view these products through a typical buy-and-hold strategy are at significant risk, given the unpredictability of their returns.

“These products pop up in the news periodically, almost always associated with investors suffering large losses or sudden fund closures. Investing in them is no different than going to a casino,” Pessina sad.

“This is an instance where the financial product is there for no good reason other than gambling,” Whaley agrees. “The issue is financial market integrity and investor protection. The problem has been around for a long time, but it’s being accentuated right now because of the influx of retail buying and selling through venues such as Robinhood.”

Their paper poses a question to the finance community: why do levered and inverse ETFs even exist? Pessina, now an investment banking analyst at Deutsche Bank in Jacksonville, Florida, continues to follow how media and policy makers respond. Whaley believes that keen interest in real problems is the key to success in research—for investing or academia.

“What I like to see in students is that intellectual curiosity,” Whaley said. “Colby has that curiosity and drive. Even after we completed the paper, he continues to send me current financial press articles related to our work. He keeps on top of it because he’s just plainly interested and engaged.”

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