A rush of retail investors and quant funds has caused a shift toward more borrowed money and more short-term trading
Leverage is transforming the stock market.
Leveraged bets led to the near-collapse of hedge fund Situational Awareness last month, while similar mistakes led to more than 1.2 million South Korean trading accounts facing margin calls as the country's stock market KR:180721 cratered last month following a historic sprint higher.
As both retail and institutional investors increasingly embrace leverage while favoring more short-term trading, blowups like these will likely become more frequent, market strategists told MarketWatch. And even though levels of leverage in certain corners of the market have ebbed from their peak levels seen shortly before July's artificial-intelligence swoon, risks remain.
"Although positioning in AI semiconductor and memory names has become less concentrated, overall leverage across retail and hedge-fund investors remains elevated. That leaves the market susceptible to additional bouts of volatility if investors are forced to reduce risk," Morningstar Wealth CIO Philip Straehl told MarketWatch.
Indeed, these risk could be around for a while. In commentary recently shared with MarketWatch, Straehl highlighted a couple of theories driving what he has identified as a shift toward more short-term trading in the U.S. equity market.
Over the past 10 years, a rush of new self-directed retail investors has flocked to the market. Meanwhile, trendy quantitative trading strategies have attracted growing interest from major asset allocators and institutions. Both classes of investors are oriented more toward short-term trading, Straehl noted.
Bouts of volatility like what investors witnessed this spring and summer could become more frequent. Hot semiconductor stocks shot higher during the second quarter as a selloff inspired by the Iran war faded, before turning sharply lower in July - putting pressure on investors who had borrowed money to chase the rally.
Some blamed the shift in sentiment on worries about increasing competition from China. Whatever the reason, shares of Micron Technology (MU), Sandisk (SNDK) and other hot AI stocks cratered; a flood of assets into leveraged ETFs likely contributed to the speed of the unwind, Straehl said.
The pain spread well beyond the U.S.: South Korean stocks sank into a tailspin as shares of Samsung Electronics (KR:005930) and SK Hynix (KR:000660) (SKHY) - two memory-chip makers that had racked up huge gains in 2026 - were hit hard. Subsequently, a rash of liquidations inspired officials in South Korea to take a number of steps to try and prevent a repeat. Measures included new restrictions on access to leveraged ETFs, and increased cash margin requirements.
The instability that hammered the South Korean equity market in July was unlike anything investors in that market had ever seen before. It also may offer a glimpse of where the U.S. might be headed if investors continue to increasingly gravitate toward these leveraged products, said Joe Saluzzi of Themis Trading.
"I would say that the South Korean market is the perfect example of how hyperactive day traders who have access to derivative products such as double-leveraged ETFs can cause a bubble to form. The higher it gets, the more it drags in the FOMO traders who often get in near the top," Saluzzi told MarketWatch. "Many of them will be using margin and will get liquidated once the bubble pops, which seems to be what happened in South Korea."
Indeed, assets managed by leveraged ETFs around the world surged earlier this year as AI mania shifted into overdrive. The chart below captures total assets under management in U.S. dollars for four popular Hong Kong-listed leveraged ETFs.
To be sure, these products still represent just a sliver of overall ETF assets, even if they're among the hottest categories for new fund launches in the U.S.
Others have warned about the risks of crowding and excessive leverage. Morgan Stanley's Michael Mauboussin has long warned that crowding can lead to inefficiencies and mispricing in markets. Owen Lamont, portfolio manager at Acadian Asset Management, has written that excessive use of leverage by retail investors is a sign that the market is turning frothy.
Whether this latest love affair with leverage in the U.S. ends the same way South Korea's did remains to be seen. But the mechanics appear the same, wherever they show up.
-Joseph Adinolfi
Comments