“I’m 67 years old, and I’m basically bankrupt in two weeks.”
That’s how an individual quoted in the Wall Street Journal last summer described the sudden collapse of a retirement portfolio comprised largely of leveraged exchange-traded products (ETPs) amid the market turmoil of March 2020 caused by the onset of the COVID-19 pandemic.
In a new paper featured by the Financial Analysts Journal, Robert Whaley, Valere Blair Potter Chair, professor of management and director of the Financial Markets Research Center at Vanderbilt University’s Owen Graduate School of Management, extends his earlier empirical work—warning of the dangers of these complex products, which are marketed and sold without restrictions to retail investors. The study was co-authored by Colby Pessina, MSF’20, an investment banking analyst at Deutsche Bank in Jacksonville, Florida.
First introduced in the early 1990s, ETPs rapidly gained in popularity among individual investors because they offered a broadly diverse portfolio—such as the S&P 500 or a bond index—in a single, easily tradable asset. ETPs have since grown to become one of the most popular (and profitable) products available, accounting for global assets under management of more than $4.2 trillion.
More recently, issuers have developed leveraged and inverse ETPs that allow investors to magnify their bets on the direction of popular financial indexes such as the S&P 500 or the Volatility Index (VIX), which Whaley developed for Chicago Board Options Exchange in the 1990s. These products offer directionality—long and short—by as much as a factor of 3 without the complexity and expense of accessing options and futures markets.
Retail investors are picking up on the products: Leveraged and inverse ETPs currently make up 11.9% of all ETPs and account for assets under management of about $50.6 billion.
“Trading costs and barriers to entry are low. Bid-ask spreads on these products are trivial for active ETPs, and commission-free brokerage, with no account minimums, is now the norm,” Pessina and Whaley wrote in the paper. Moreover, because leveraged and inverse ETPs are equity securities, not derivatives, retail customers and certain institutions can now short sell and achieve leverage factors that were not possible for them beforehand.
And yet, as the authors demonstrate, these products carry significant risks, particularly for unsophisticated investors who may use them with a long-term “buy-and-hold” strategy.
“The fact of the matter is that the value-destroying characteristics of these products are not well understood,” Pessina and Whaley explained.
Because of how these products are structured, prices veer from their “promised” levels through time. And hefty expense ratios erode value. Statistical models used in the paper, in fact, show that, regardless of the factor or asset class, many ETPs will die, absent corporate actions such as reverse splits. Indeed, just after their study was originally released in March 2020, two sets of directional oil ETPs were liquidated.
“The problem is inherently much deeper than investor education. Why do the products exist?” Pessina and Whaley asked in the paper. “Levered and inverse products are not, and cannot be, effective investment management tools.”