Buyers should beware the dangers of new ETFs
High leverage and insufficient oversight could amplify risks for individuals and markets
The editorial board
This has been an eventful summer for the South Korean stock market.
The Kospi, the country’s benchmark index, doubled in the first six months of the year before collapsing in late July.
Its rise and fall were turbocharged by widespread retail purchases of a relatively new financial trend: leveraged exchange traded funds in single stocks.
These ETFs, which in the Korean case largely tracked the performance of Samsung and SK Hynix (the index’s two largest stocks), use derivatives to amplify returns, giving retail investors access to previously unavailable leverage.
The domestic fallout has been considerable: as the market fell, ETF-driven swings fuelled a wave of margin calls, adding to the pain for investors.
Korea’s summertime meltdown is no quirky aberration.
It should serve as a clear lesson to the world about how risky new products and high leverage are dramatically amplifying the volatility of markets.
ETFs, long a favourite of retail investors, were originally a plain-vanilla, low-risk instrument designed to provide easy access to large, diversified baskets of stocks tracked by an index.
Today more than $22tn worth of ETFs globally track everything from equities to bonds and commodities, as well as a growing range of “active” asset selections.
America’s S&P 500 is tracked by over $2tn in State Street and Vanguard funds alone, which buy and hold large pools of assets, charge very low fees and allow retail investors on different brokerage platforms to invest as little as $1 apiece.
But investment firms are now targeting retail investors with more complex products ranging from leveraged single-stock ETFs to inverse ETFs that enable them to “short” a stock, or bet on its price falling.
These new strategies inject higher risks into retail portfolios by boosting gains and losses alike.
Many new-style ETFs provide retail investors with investments they do not fully understand.
They also do not necessarily act in ways that investors expect.
By settling daily, these products can diminish the long-run returns of more volatile stocks.
ETFs can also contribute to market volatility in aggregate, as in Korea.
Leveraged, single-stock, and inverse ETFs amplify swings in wholly new ways.
Yet these new and different ETFs are booming.
More than 1,000 ETFs have launched just this year, of which almost a quarter have been leveraged single-stock funds.
These new ETFs exemplify the way in which increasingly speculative products are being marketed to retail investors: from cryptocurrencies and prediction markets to zero-day options in India that bet on a stock’s single-day movements, many products look less like investments and more like gambling.
South Korea’s regulators are responding to their domestic market moves with new rules intended to avoid a repeat of the swings investors experienced with leveraged ETFs.
The country now requires single-name fund holders to take education courses before buying.
Other countries can learn from the Korean example, before suffering similar rollercoaster rides.
There should, of course, be an onus on buyers to vet what they buy.
But better financial literacy and education would help retail investors evaluate new products.
Investors in many markets would benefit, too, from stronger disclosure requirements that spell out the risks.
Micro-risks, though, are not the only concern for authorities.
The leverage built into newfangled ETFs, as well as many other areas of today’s booming markets, should be of growing concern to prudential watchdogs and an integral part of stress tests.
A highly leveraged market with high retail participation has unpleasant echoes of past crashes.
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