South Korea's stock market faces extreme volatility from leveraged ETFs

South Korea's stock market is grappling with intense volatility, a situation exacerbated by a surge in short-term trading strategies. The recent launch of leveraged exchange-traded funds (ETFs) focused on single stocks, specifically Samsung Electronics and SK Hynix, has significantly amplified this trend.

In the first week of their release, from May 27-29, leveraged ETFs tracking these tech giants dominated the list of highest daily turnover rates. One such ETF, 'SOL SK Hynix Futures Single Stock Inverse 2X,' recorded an astonishing 2014.31% turnover on May 28 alone. This means the entire stock of the ETF changed hands more than 20 times in a single day. Many other similar products also saw turnover rates between 100-200% daily, starkly contrasting with the much lower turnover rates of Samsung Electronics and SK Hynix themselves (0.77% and 0.79% respectively on June 1).

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These ETFs were intended as hedging tools within a portfolio, but by focusing on the two stocks that make up 50% of the market, it's become a case of the tail wagging the dog.

Leveraged ETFs, which amplify the daily returns of underlying assets by a factor of two, are inherently designed for short-term trading due to a phenomenon known as negative compounding, which erodes long-term returns. While high turnover was anticipated, the current level of market activity has surpassed expectations. "These ETFs were intended as hedging tools within a portfolio, but by focusing on the two stocks that make up 50% of the market, it's become a case of the tail wagging the dog," said Lee Jun-seo, a professor of business administration at Dongguk University. He added that while authorities might have introduced them to capitalize on a rising market, their impact on the broader market is too significant, necessitating a speed adjustment.

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South Korea has historically had a strong betting culture in investments, with its futures and options trading volume once topping global rankings. In a way, the current short-term overheating was predictable.

The high frequency of trading is largely driven by individual investors, who are more susceptible to short-term trading temptations due to less access to information compared to institutional investors. Between May 27-29, individual investors were net buyers of 3.3 trillion won in these ETFs, while foreign investors net bought 300 billion won, and institutions were net sellers of 3.7 trillion won. "South Korea has historically had a strong betting culture in investments, with its futures and options trading volume once topping global rankings. In a way, the current short-term overheating was predictable," noted Kim Dae-jong, a professor of business administration at Sejong University.

Financial authorities are keenly observing the escalating market volatility, particularly concerned about the potential for substantial financial losses among individual investors who might be using these funds for retirement or living expenses. The Financial Supervisory Service (FSS) is continuously scrutinizing the sales practices of brokerages that might encourage excessive leveraged investments and is exploring phased responses. "We are strictly preventing brokerages from engaging in exaggerated advertising or organizing events that incite excessive trading," stated a senior FSS official, adding that further measures would be considered if volatility continues to increase. Professor Lee also suggested the need for additional measures, such as re-education, to cool down market overheating.

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We are strictly preventing brokerages from engaging in exaggerated advertising or organizing events that incite excessive trading.