South Korea's stock market has undergone a severe deleveraging process over the past month, with the KOSPI index falling nearly 40% from its June 22 peak. However, based on the scale of leveraged products, hedge fund positions, retail investor margin debt, and foreign capital flows, the primary forced liquidation forces driving the decline have been substantially released. The market currently shows no signs of a chain of risk events triggered by retail investor margin calls and foreign capital withdrawal.
According to a report from JPMorgan Chase released on July 29, the deleveraging process for South Korea-related leveraged ETFs is largely complete, with hedge funds having completed approximately 90% of their deleveraging adjustments. The forced selling by highly leveraged funds during the market decline amplified index volatility and prompted other investors to reduce positions simultaneously.
Foreign investors have sold over $110 billion worth of South Korean stocks this year, a significant amount, but approximately 90% of this outflow is concentrated in two memory chip giants. As the weight of these two stocks in the MSCI Emerging Markets Index has fallen from 9.5% and 8.3% at the end of June to the current 6.5% and 4.5%, the passive selling pressure driven by portfolio constraints is diminishing.
In the short term, the South Korean market still faces uncertainties such as the Federal Reserve's interest rate meeting, potential rate hike risks, and high earnings expectations for large cloud computing companies. The market's price losses this week could also trigger residual position unwinding in the coming days. However, JPMorgan believes that with valuations already at low levels and earnings momentum still present, the positioning structure of the South Korean stock market has become more attractive compared to before.
Nearly 40% Decline: The Core is Concentrated Holdings and Leveraged Liquidations
This round of adjustment began in mid-June. JPMorgan notes that the initial triggers were conventional fundamental concerns and sector rotation, but the highly concentrated structure of the South Korean market, coupled with the amplifying effect of leveraged ETFs, quickly turned the decline into a deleveraging trade.
The KOSPI's retracement aligns closely with the significant underperformance of memory chip stocks. Previously, a small number of large-cap stocks dominated South Korea's market performance, with narrow breadth in the rally. When these high-weight stocks adjust, the index comes under particular pressure.
However, during the July market decline, the number of advancing versus declining stocks remained relatively stable, suggesting losses are still concentrated in a few heavyweight stocks rather than spreading broadly across the entire market. This weakens the judgment that a "widespread balance sheet deterioration" is forming.
JPMorgan's chart shows that the KOSPI's current technical indicators have entered oversold territory, with a forward price-to-earnings ratio of around 5 times. Expected free cash flow valuations are also at what the firm calls "crisis levels." Low valuations do not mean volatility will end immediately, but they provide a buffer for the market to rebuild risk appetite once deleveraging nears completion.
Leveraged ETF Assets Have Fallen from $50 Billion to $17 Billion
Leveraged ETFs were a key channel amplifying this round of volatility. By the end of June, the assets under management (AUM) of leveraged ETFs linked to the South Korean market reached approximately $50 billion. Relative to the size of the South Korean market, this scale was about four times the comparable level in the United States.
During market declines, leveraged ETFs need to passively reduce risk exposure, creating a feedback loop of "falling prices, forced selling, and further falling prices." Such trading not only impacts the related stocks but can also force other investors with similar holdings to withdraw simultaneously.
To date, the AUM of these products has fallen to around $17 billion. JPMorgan believes this scale has returned to a level that no longer poses a prominent risk. Concurrently, recent inflows into leveraged products have noticeably stalled, and buying on dips is not active.
The ebbing of leveraged ETFs is also reflected in volatility indicators. The report notes that the ratio of South Korea's volatility index, VKOSPI, to the US VIX has begun to decline, and open interest in single-stock futures continues to fall. For the market, this suggests that sharp volatility driven by derivatives and passive rebalancing may be cooling down.
Hedge Fund Deleveraging Nears Completion
Hedge funds are another source of risk to monitor. JPMorgan data shows that the long/short leverage ratio for hedge funds in its prime brokerage accounts once rose to 5.7 times before falling to 3.2 times on July 27.
The report indicates that the significant pullback in price momentum factors on July 28 and 29 suggests hedge funds may have further reduced leverage. Currently, their leverage level is not far from the upper end of the 2025 range, with the overall deleveraging process approximately 90% complete.
This does not mean selling pressure has completely disappeared. Further market declines could still trigger adjustments in some remaining positions, especially with macroeconomic events approaching and investor risk appetite cautious. However, compared to when high-leverage positions were still heavily accumulated, the probability of continued systemic forced liquidations is decreasing.
From a market transmission perspective, the simultaneous contraction of leveraged ETF and hedge fund positions is a key explanation for the KOSPI's rapid short-term decline. Both are shrinking, meaning the most destructive trading structure from before is improving.
Retail Investor Margin Debt Does Not Support a "Widespread Margin Call" Judgment
The retail investor risk highlighted in headlines is one of the easiest transmission links for the market to worry about. But JPMorgan believes that the leverage built by South Korean retail investors through margin trading is not high and did not expand rapidly this year.
Current margin debt is approximately $20 billion, down from previous levels. More importantly, the ratio of margin debt to total market capitalization has actually been on a downward trend this year.
Unlike leveraged ETFs, which can trigger mechanical deleveraging when spot prices fall, margin loans typically come with a buffer and operational discretion. The report believes South Korean retail investors still have previously accumulated stock gains, cash balances, higher income, and overseas assets to cope with potential margin calls, provided they choose to maintain their positions.
Therefore, while some retail investor leverage adjustments exist in the market, the available data does not support the conclusion that margin debt constitutes a large-scale, indiscriminate risk of margin calls. The retail side is more likely one of the amplifiers of volatility, not the main source of current market risk.
Foreign Outflows Hit Record, But Selling Pressure is Highly Concentrated
Foreign outflows are another signal that has put the market on alert. Since the beginning of the year, foreign investors have sold over $110 billion worth of South Korean stocks, a considerable amount.
But JPMorgan points out that approximately 90% of the foreign outflow comes from two memory chip stocks, driven primarily by long-term funds facing portfolio constraints due to their large holdings. As the related stocks fell, their weight in the MSCI Emerging Markets Index has significantly decreased, dropping from 9.5% and 8.3% at the end of June to 6.5% and 4.5%, respectively.
The decline in weight means reduced pressure for passive or benchmark-constrained funds to continue selling. The report states that with the South Korean market, particularly memory chip stocks, underperforming, the selling pressure from long-term funds has notably eased.
Furthermore, not all sectors in the South Korean market are experiencing foreign capital withdrawal. The report shows that even during the KOSPI adjustment period since June 22, several industries still recorded net foreign buying. This suggests that fund flows are more consistent with a rebalancing of concentrated holdings rather than a comprehensive retreat from South Korean assets.
Valuations and Earnings Provide a Buffer; Short-Term Still Depends on External Events
With deleveraging nearing its end, the market's next phase will depend more on macroeconomic risks and corporate earnings expectations. JPMorgan specifically cautions that the Federal Reserve meeting carries a risk of rate hikes, and high earnings expectations for large cloud computing companies could impact global tech and risk asset sentiment.
The South Korean market is sensitive to memory chip prices and industry chain expectations. The report states that spot memory chip prices are generally still rising, and third-quarter contract prices continue to increase, albeit at a slower sequential growth rate. This supports market earnings expectations, but also means that changes in price trends or tech demand expectations could still generate significant volatility in the highly concentrated sector.
From a positioning perspective, JPMorgan believes the current combination of low valuations, earnings momentum, and leverage cleanup in the South Korean market forms a relatively favorable setup. The firm continues to favor sectors driven by a "wealth effect," such as department stores, cosmetics, tourism, brokerages, and construction, while also watching previously lagging sectors like biopharmaceuticals, preferred stocks, and banks.
For investors, the key for the South Korean market is no longer just whether the index decline will widen, but whether passive selling continues to contract, whether heavyweight memory chip stocks can stabilize, and whether external macroeconomic events will trigger another round of universal deleveraging in risk assets. At this stage, the South Korean stock market has not escaped high volatility, but the chain of "retail investor margin calls – foreign capital flight – market chain crisis" lacks sufficient data to support it.
Comments