Leveraged bets have caused extreme volatility in South Korean stocks. The KOSPI index has seen significant declines and gains recently. Billions of dollars in leveraged bets on South Korea’s AI favorites have transformed a stock market once revered as a reliable barometer of global growth into a wildcat casino, confounding regulators and investors alike.
That volatility, felt on trading desks from Tokyo to New York, has not only wreaked havoc on portfolios but has also dramatically distorted investors’ views on fundamentals in South Korea, a market at the heart of the global AI boom.
More than half of all stock market breakers on the benchmark KOSPI index (trading restrictions that are triggered when the index loses more than 8 percent for at least one minute) in South Korea’s history have occurred in the past six months alone.
“The index has been decoupled from all historical factors in Korea,” said Alexander Redman, chief equity strategist at CLSA.
“Korea had been an easy market for strategists, with loyal long-term relationships… to (help) choose entry and exit points,” he said. Those relationships have since broken down and the main price drivers right now are capital flows from an explosion of single-stock leveraged funds, which promise amplified returns but have exacerbated volatility. The main targets of these funds are chipmakers Samsung Electronics and SK Hynix, big winners in the AI supercycle that now account for more than half of the KOSPI.
The market is moving away from fundamentals. This is not about assessing the full scope of future earnings, with price-earnings ratios at Samsung and SK Hynix falling below 5, nor responding to generally reliable economic correlations.
KOSPI volatility has soared and prices once tracked by U.S. benchmark indices are now weighing on Wall Street as a rally that doubled the index’s market value in six months has turned sharply, losing 20 percent so far this month.
“In the past, if Korea fell 7 percent on the day, I wouldn’t talk to you,” Redman said. “Now it is normal, but it is increasingly worrying institutional investors.”
DIVORCED FROM THE FUNDAMENTALS South Korean retail investors had 34.37 trillion won ($23 billion) in margin loans at stake this week, slightly below June’s record of 38.6 trillion won, in what has become one of the strangest bear markets in recent memory.
The rally is based not only on a mountain of borrowed cash, but also on extremely concentrated bets routed through leveraged exchange-traded funds.
The assets of a twice-leveraged SK Hynix fund listed in Hong Kong have risen more than 20-fold since the start of the year to $7.78 billion, making it the largest such fund globally, with rebalancing flows large enough to tip the market.
“Some of the single-name leveraged ETFs have four times the average volume of the underlying stocks,” said Florian Neto, Asia chief investment officer at Amundi.
“When assets under management skyrocket, we see the limits of the exercise of leveraging single names; this sends us some warning signs,” he said.
Regulators are trying to move between “dampening excesses,” without raising concerns about a widespread crackdown that could spook investors and trigger the volatility they are trying to curb.
This week, South Korea attempted to block new launches of single-stock leveraged funds. Starting August 5, the minimum cash balance required to trade individual stock leveraged ETFs – including those listed overseas – will triple to 30 million won ($20,300).
“Volatility in the Korean equity market has been crazy recently,” said Mike Sell, head of global emerging market equities for London-based asset manager Alquity.
“Therefore, measures to restore focus on fundamentals can only be welcomed… a return to rationality will be positive for long-term investors, in our view.”
Can you gain leverage?
Without a doubt, the market transformation has winners, among them the growing chip manufacturers.
Insatiable investor appetite helped SK Hynix achieve the largest US capital raising ever by a foreign company last week, raising $26.5 billion.
“Hot capital is actually causing permanent changes in companies,” said Michael Green, chief strategist and portfolio manager at Simplify Asset Management.
Still, for investors, who according to the Bank of America fund manager survey believe that an AI bubble is the main risk facing markets, the movements in the Korean market are important.
“In fact, I think it’s right that almost every investor in the world is paying close attention to what’s happening in Korea,” said Damien Boey, portfolio strategist at Wilson Asset Management in Sydney.
“The bullish scenario is that earnings growth continues, leverage gains, and Korean stocks fly. I don’t think the market action is saying the story is that simple.”
