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South Korea's stock market fell 44%
The leveraged ETFs
The products tracked Samsung and SK Hynix and multiplied daily returns by two, three, even five times. Retail investors made up 92% of the buyers, and there were two brokerage accounts for every citizen in South Korea.
Who got hurt
Goldman estimates that 3.4% of the country's adult population has received a margin call. Around 70% of the people invested in SK Hynix and Samsung are in the red, as reported by Korean stock market regulators.
The aftermath
On the sidewalk outside the National Assembly building in Seoul, a pile of funeral wreaths sits beside a sign reading abolish the single stock leveraged ETF. South Korea has rolled out a debt counseling hotline as part of its suicide prevention plan, and its regulators will stop allowing new listings of single-stock leveraged ETFs.
How does a leveraged ETF multiply returns?
A leveraged ETF holds derivatives such as swaps and futures contracts that deliver a multiple of the underlying stock's move. The multiple applies to a single day, and the fund resets every day. Over several days, compounding makes results drift away from the multiple of the period's total return. If a stock falls 10% and then rises 10%, it ends at 99 from a start of 100, while a 2x fund falls 20% to 80 and then rises 20% to 96.
Why do leveraged funds sell into falling markets?
To hold a constant multiple, a leveraged fund must rebalance its exposure at the end of each day. After a fall, the fund's assets have shrunk, so keeping the same multiple means reducing exposure by selling. After a rise, it must buy more. The rebalancing therefore adds to selling on down days and to buying on up days. The SEC and FINRA have issued investor alerts stating that these funds are designed for holding periods of a single day.
How does a margin call spread across a market?
Forced sales push prices down, which cuts the value of the collateral held by other borrowers and triggers further margin calls. Lenders also tend to raise margin requirements when markets turn turbulent, which forces more sales. Economists Markus Brunnermeier and Lasse Pedersen described this feedback as a loss spiral in a 2009 paper titled 'Market Liquidity and Funding Liquidity.' It appeared in the Review of Financial Studies.
How did Korean retail investors become a market force?
Individual investors in South Korea are known as 'ants,' or gaemi in Korean. During the pandemic in 2020, a wave of new individual investors, nicknamed the 'Donghak ants,' bought domestic shares in large numbers. The KOSPI index passed 3,000 for the first time in January 2021.
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