The dilemma of single-stock leveraged ETFs

Ha Hyun-ock

The author is an editorial writer at the JoongAng Ilbo.

“Single-stock leveraged products are unsuitable for long-term investment because their ‘leverage effect’ can magnify gains and losses from a small initial investment, causing large losses in a short period. They also expose investors to the ‘negative compounding effect,’ in which repeated rises and falls in a stock price gradually erode principal.”

That warning did not come from a product prospectus. It appeared in a press release issued by financial regulators on May 26, the day before leveraged exchange-traded funds (ETF) tied to Samsung Electronics and SK hynix began trading.

Unusually for an official statement, the release was filled with cautions about the products and the risks they posed. As if preparing an alibi, regulators even cited foreign cases in which investors had lost all of their money. Like the grim warning labels on cigarette packs, it seemed to herald the arrival of a financial bomb capable of shaking the market.

It took less than 50 days to confirm the bomb’s destructive power.

Caught in a vortex of volatility, the stock market has been devastated. Riding on leverage, investors have watched the market collapse. Less than a month after the launch of the single-stock leveraged ETFs on May 27, the Kospi index hit a record high of 9,114.55 on June 22. Just over 20 days later, on Monday, it fell below the 7,000 mark.

Investor losses mounted. As of July 8, every single-stock leveraged ETF was trading below its listing price of 20,000 won ($13.40). The products had become monsters consuming the market.

Since their debut, the stock index has behaved like a roller coaster. Market safeguards designed to cushion shocks — sidecars and circuit breakers — have become routine. Sidecars, which temporarily curb program trading, had been triggered 55 times this year through Tuesday.

Circuit breakers, which halt trading for 20 minutes when the index moves more than 8 percent from the previous day and stays there for at least one minute, have been activated seven times this year alone. That is more than half of the 13 times they have been used since the system was introduced in 2000. Five of those seven suspensions occurred in June and July, after the leveraged ETFs were listed.

Extreme volatility has turned the Kospi into what critics call a state-sanctioned casino.

The reason a single product can wag the dog lies in its structure. Leveraged ETFs are designed to amplify the gains and losses of an underlying asset by a predetermined multiple. In a two-times leveraged fund, for example, a 1 percent increase in the underlying asset produces a 2 percent gain. Losses are magnified in the same way.

Because of this structure, asset managers must rebalance their holdings at the end of each trading day to maintain the promised leverage ratio. When prices plunge, they are forced to dump shares mechanically before the market closes.

What amplified the market shock was the fact that the underlying assets consisted of individual stocks rather than a diversified basket.

Samsung Electronics and SK hynix together account for roughly half of the Kospi’s market capitalization. As fund managers sold shares in those companies to maintain leverage ratios during market downturns, the stocks declined further, dragging down the broader index and triggering sidecars and circuit breakers in a domino effect. The market increasingly resembled a gambling table.

The government itself helped create the explosive potential of these products.

Until recently, regulations limiting the weight of any single stock to 30 percent and requiring at least 10 constituent stocks effectively prevented the launch of single-stock leveraged ETFs. That changed after Kim Yong-beom, the presidential chief of staff for policy, said in a newspaper interview earlier this year that he had instructed the Financial Services Commission to introduce high-leverage, single-stock products.

The commission quickly announced plans to permit them. The goal was to encourage Korean retail investors who had poured money into overseas equities to return to the domestic market and, in doing so, help stabilize the soaring exchange rate.

Instead, the move opened the door for investors gripped by FOMO — the fear of missing out — to double down on an already overheated stock market.

As money flooded in, the new ETFs became black holes, sucking liquidity out of the broader market. Capital that might otherwise have flowed into smaller companies or strong businesses in other sectors dried up. The healthy functions of the capital market weakened.

Countless investors found themselves aboard a plunging train, often without understanding why prices were collapsing. The backlash became so severe that an online petition submitted to the National Assembly called for the products to be abolished altogether.

The problem is that the authorities that created this monster now seem to have no obvious solution. Delisting the products, as some politicians have proposed, is unrealistic and could unleash another wave of confusion and market turmoil. The remedies under discussion amount to little more than temporary patches.

Having failed to achieve their original goal of stabilizing the exchange rate, regulators are trapped in a dilemma. They can neither kill nor save the Samsung-SK hynix leveraged ETFs. As authorities waver, it is ordinary retail investors who are left to bear the cost.