Global investors pulled out of South Korean stocks during July's turmoil, but remain optimistic about the growth prospects of the country's heavyweight chipmakers.
Leveraged positions that had previously rocked the market appear to have been reduced, boosting investor confidence in these companies. During last Friday's record rally in South Korean stocks, foreign investors ended a period of net selling that had persisted since the start of the year, instead buying 7.2 trillion won (approximately $5 billion) in South Korean stocks. This amount more than doubled the previous single-day record.
In contrast to the renewed foreign buying, domestic retail investors in South Korea have been hit hard as the stock market has fallen about 40% from its June peak. Samsung Electronics reported a massive 250-fold surge in chip profits, supported by data center demand, but its stock price dropped from a June peak to a late-July trough, nearly halving its market capitalization. Rival SK Hynix experienced a similar trajectory. Shares of both companies rebounded strongly during last Friday's volatile trading.
Steve Lawrence, Chief Investment Officer at US-based Balfour Capital Group, which manages over 400 million euros in assets, stated: "This was a leverage event, not an earnings event." He added, "Let me put it bluntly: I am strongly bullish on Samsung Electronics at these levels. It was sold off simply because it accounts for half the index weighting, not because of any issues with its business." He further noted, "The logic of the memory chip cycle and AI capital expenditure remains intact, but the liquidation of leveraged positions allows you to buy this stock at a discount that fundamentals cannot explain."
Leverage liquidation amplified market volatility
JPMorgan Chase research shows that assets under management for leveraged exchange-traded funds (ETFs) with Samsung Electronics and SK Hynix as underlying assets fell from $50 billion in late June to $17 billion last week. The struggling hedge fund Situational Awareness was forced to sell stocks, exacerbating the decline in South Korean stocks. After Citadel Advisors acquired the majority of the fund's remaining stock portfolio, this selling wave appears to have ended.
Data from analysis firm EPFR indicates that active global emerging market funds had been steadily increasing their allocation to South Korean assets over the past 18 months, but this allocation leveled off in June as market volatility surged. The rise and fall of South Korean stocks have been increasingly influenced by leveraged fund behavior. A team of analysts led by Rajiv Batra, JPMorgan's Head of Asia and Co-Head of Global Emerging Markets Equity Strategy, said: "In South Korea, we believe the liquidation of leveraged ETFs has been completed, and hedge funds have also completed about 90% of their deleveraging, returning to acceptable levels." They added that after previous emerging market corrections, the median 12-month return was about 28%.
Leverage has changed the way South Korea's stock market operates. Through products like single-stock leveraged ETFs, leverage accelerated market rallies and amplified declines during pullbacks. In the 12 months leading up to the June peak, the benchmark Kospi index more than doubled. The rally accelerated further after single-stock leveraged ETFs were launched in the South Korean domestic market in May, subsequently adding to the pressure on stocks as they fell from their highs. William Brattan, Head of Asia-Pacific Cash Equity Research at BNP Paribas, said: "Long-only investors simply do not want to manage their positions in such volatile stocks."
Policy and market risks remain after the rebound
The drastic crash prompted South Korean Finance Minister Choi Sang-mok to issue a public apology. He admitted that these ETFs were introduced without sufficient consideration and subsequently announced new measures to limit leveraged products. Citigroup's trading strategy desk estimated last week that retail investors' total losses on leveraged ETFs amounted to approximately $38.7 billion. This massive loss has further fueled public anger towards policymakers, who are seen as having allowed the introduction of single-stock leveraged funds, a key factor leading to significant retail investor losses.
Pierre Hoebrechts, Deputy Chief Investment Officer at East Eagle Asset Management, commented: "The scale of money flowing into SK Hynix and Samsung Electronics is staggering." He added, "South Korea's huge number of retail trading accounts, combined with local leverage and extremely concentrated risk exposure, compounded by the massive scale of leveraged foreign ETFs, all made this a disaster waiting to happen." Hoebrechts revealed that his firm had been shorting the Kospi index and Japan's Nikkei index since late June, but closed those positions last week, judging that this thorough washout might be nearing its end.
According to data from S3 Partners, the average short position in the South Korean market, weighted by position value, is about 4.3%. This is lower than the recent peak of around 5.3%. However, the market still faces many risks. Last Friday's record 17.9% surge in the Kospi index was as unsettling for investors as the cliff-like drops seen in the previous month. The index fell nearly 5% again on Monday, suggesting that while leverage liquidations may be nearing completion, market volatility has not completely disappeared. Larry Hatheway, Head of Research at the Franklin Templeton Institute, stated that while US institutional investors remain cautious about entering a falling market, they "may now be willing to reconsider some of these (South Korean) stocks."
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