A team of strategists from Xingzheng Securities, led by Zhang Qiyao, believes that the unwinding of leveraged funds in the South Korean stock market is currently less than halfway complete. The current decline in margin balance is 13.6%, significantly lower than the historical peak declines of 30% to 70%. While the size of leveraged ETFs has fallen by over 40%, this is almost entirely attributable to declining net asset values, as these funds actually saw net inflows of nearly $6 billion during the market adjustment phase. Leveraged ETFs are considered the most critical indicator to monitor. A reduction in their size to levels seen in early April or a shift to sustained outflows from their liability side could be interpreted as a signal that leverage pressure has been cleared. Recent positive signals include a return of foreign capital inflows and a stabilization of retail margin balances.
Evaluating the Extent of Leverage Unwinding
Regarding the extent of leveraged capital reduction in the current South Korean stock market cycle, we observe from four key dimensions:
1. Margin Balance: Compared to the maximum declines in margin balance during previous deleveraging episodes, the current unwinding process is less than halfway through. As of July 16, the margin balance for South Korean stocks stood at 33.36 trillion won, accounting for 0.57% of the total market capitalization. The current margin balance has declined 13.6% from its peak, with the deleveraging speed faster than during the 2018 and 2022 bear markets but slower than during the 2008 subprime mortgage crisis. When compared to the maximum declines of 30% to 70% seen in previous deleveraging periods, the current process of leverage unwinding is not yet halfway complete.
2. Retail Brokerage Margin Balances: These have declined to relatively low levels seen since early February. As of July 16, retail brokerage margin balances fell by 28.7 trillion won to 108.1 trillion won, reaching a relatively low level not seen since early February this year. This indicates a significant reduction in the purchasing capacity of retail investors.
3. Forced Liquidation Scale: This has declined significantly from recent highs. From July 13 to July 16, the scale of forced liquidations in South Korea was around 100 to 400 billion won, with the proportion relative to unpaid margin falling below 4%. This marks a notable decline from the previous high of 1.4 trillion won, representing 10%.
4. Leveraged ETF Size: While the size has declined significantly, this is almost entirely due to falling net asset values. In fact, the share units of most ETFs increased against the market trend. As of July 16, the Assets Under Management (AUM) of the top ten South Korea-related leveraged ETFs fell from $43 billion to $25 billion. The leverage exposure as a percentage of South Korea's market capitalization decreased from 2.1% to 1.6%. It is estimated that the rebalancing fund flows triggered by every 5% stock price fluctuation, as a proportion of South Korea's average daily trading volume over the past month, decreased from 17% to 11%. Notably, the decline in size during this cycle is almost entirely due to net asset value depreciation. The share units of most leveraged ETFs actually increased against the trend, with these top ten leveraged ETFs recording net inflows of nearly $6 billion during the South Korean market's adjustment phase.
Core Indicator for Monitoring
Among these four dimensions, considering their proportion of market capitalization, trading volume, and contribution to net inflows, we believe leveraged ETFs are the most critical indicator to monitor. Changes in their AUM show a high positive correlation with South Korean stock market volatility. A reduction in leveraged ETF size to levels seen in early April or a shift to sustained outflows from their liability side can be interpreted as a clearance of leverage pressure.
Current Positive Signals
In summary, some current positive signals in the capital flow landscape include:
1) The size of the top ten leveraged ETFs has fallen by over 40% from the peak, reducing the impact of market maker Gamma hedging triggered by stock price fluctuations, particularly for stocks like SK Hynix Inc.
2) South Korea's domestic leveraged ETF for Samsung Electronics Co Ltd saw sustained redemptions by retail investors over the first three trading days of this week.
3) South Korean retail margin balances have shown signs of stabilization.
4) Foreign capital has shifted from a pattern of unilateral outflows to periodic inflows. Goldman Sachs Prime Brokerage data also indicates a recent return of hedge fund flows. Historical experience suggests that a return of foreign capital often corresponds to an upward inflection point in the market.
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