Just over two months ago, South Korea’s financial regulator approved investment products providing leveraged access to its two largest stocks: Samsung and the now-infamous chip maker SK Hynix. These leveraged single-stock exchange-traded funds (ETFs) offered investors double the return of the stocks. The idea was to entice local investors away from similar US products and bring assets back to the home market. And it worked – perhaps too well.
South Korea’s retail investors poured $9.4 billion (14 trillion Korean won) into these funds in less than two months. The problem was, they launched at a terrible time for the country’s two star stocks. Both had seen huge gains in the first half of the year, but just as South Korea’s retail buyers got access to leverage, the world began to lose its blind faith in AI, while competition from China threatened SK Hynix’s near-monopoly in the AI chip market.
This led to a correction in tech, hitting chip stocks like Micron, Intel, and SK Hynix particularly hard, as well as Nvidia – SK Hynix’s biggest customer. On the worst day, SK Hynix and Samsung fell 14.7% and 13.4% respectively. This was bad enough on its own, dragging down South Korea’s concentrated KOSPI index and repeatedly triggering trading stops. But the leveraged ETFs truly made the regulators rue the day the approved them.
Volatility loops
That’s because in order to give investors double the gains and double the losses of the underlying stocks, the issuers of these leveraged ETFs have to hold twice the value of the stock at the end of each day. That means buying more as the stock rises and selling more when it falls. This creates a volatility loop, exaggerating the price moves in both directions.
These wild price swings meant that investors holding leveraged ETFs were left nursing huge losses. According to a calculation by South Korea’s investment firm Hanyang Securities, Samsung’s and SK Hynix’s shares fell 15.2% and 18.4% respectively between May 27 and July 22, while the leveraged ETFs tracking them were down 40.2% and 49.4% respectively – more than double the losses of the underlying stocks.
Even that’s not the worst part, though. It might seem that if you just wait out the volatility, the stock will eventually recover and you get all your money back. Unfortunately, that’s not how leveraged ETFs work in a volatile market.
Hangyang Securities simulated what would happen if the same volatility carried on for a year, and found that even if SK Hynix and Samsung returned to their original price by the end of that year, the leveraged ETFs would still be down 63%-75%. In other words, even if the stocks eventually recovered, investors in these funds would be severely underwater.
That’s because the ETFs don’t simply track your original investment – they rebalance to give you exactly double the stock’s return on any given day. That process is called volatility decay. It becomes a major issue during volatile markets – and the longer you’re invested, the worse it gets. While not all leveraged ETFs do this daily rebalancing, the vast majority do.
Closer to home
The recent volatility in South Korea’s market was exactly that kind of environment, and the stories of the losses suffered by retail investors are brutal. But it’s not just South Korea’s problem. In fact, its leveraged ETFs were copycats of similar products that already existed in the US, tracking tech giants like Nvidia, Tesla and Microsoft – products that are available for you to buy via apps like Robinhood.
These products amassed $65 billion in assets as of June, with 90% of trading coming from retail investors. Yet some are already nursing similar losses to those seen in Korea. For example, an ETF giving you two times the performance of Tesla is down 51% over six months, despite Tesla’s stock only falling 20% over the same period. Another such ETF providing 2x exposure to Microsoft is down nearly 12% so far this year, even though Microsoft is actually up around 2% after a recent strong recovery.
That’s volatility decay in action. And that’s why the US securities regulator, the Securities and Exchange Commission (SEC), needs to step in to protect retail investors at home, before there’s a repeat of South Korea’s market meltdown.
An outright ban
It’s not that the SEC isn’t aware of the issues. Its Investor Advisory Committee found back in June 2023 that retail investors make up the vast majority of holders of these single-stock leveraged ETFs, warning that “many buy-and-hold retail investors do not understand the potential effects of compounding and daily rebalancing… such that the performance significantly diverges from the underlying stock when held over a longer period of time”.
That’s exactly what caught South Korean investors off guard, even with mandatory educational courses required before they could access these products. It’s simply too counterintuitive. In the US, no such requirement exists at all.
The SEC is now conducting a review of its ETF rules, with a public comment period open through early September, explicitly covering “novel ETFs” including single-stock strategies and heightened leverage. Now is their chance to act.
There are risky and volatile investments, and then there are investments that are stacked against you. These products fall squarely in the latter category. All single-stock leveraged ETFs are doing is exposing retail investors to unnecessary risks.
So don’t wait for the public to give their verdict on a product they may not fully understand – ban them outright, before America’s retail investors suffer the same losses as their South Korean counterparts.
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