Update on the de-leveraging process in Korea (2)
The KOSPI’s recent decline has substantially normalized leveraged ETF and hedge-fund positioning. With valuations and earnings momentum still supportive, the report sees Korea’s setup as attractive on balance.
The Korea market has undergone an intense period of de-leveraging since mid-June. The KOSPI index is now down almost -40% from the peak on 22 June in a highly volatile move. What was triggered by routine fundamental concerns and rotational flow was amplified by leveraged ETFs, and in recent days increasingly has the hallmarks of hedge fund positioning unwind. Following our update last week (where we estimated that leveraged ETF unwind was 75% through and equity H/F de-leveraging >50% through), we now believe that leveraged ETF unwind is complete and hedge funds are done with ~90% of de-leveraging (both to acceptable levels). While it is likely that the price damage we have seen this week has residual spillovers into further de-leveraging over the coming days, and that many investors continue to exercise caution into the FOMC this week (high risk of a rate hike) and hyperscaler earnings (high expectations), the positioning setup in Korea now appears attractive on balance – and complements the cheap valuations and earnings momentum.
- De-leveraging update: (1) Leveraged ETFs AUM has normalized: Leveraged ETFs with Korea underlyings grew to $50bn in AUM by late June. Relative to its market size, this was 4x larger than the US and led to very pronounced volatility (and forced de-leveraging on down-days – which then caused positioning unwinds from other investors). With the reversal of the market, this cohort is now down to $17bn. In addition, the previously rapid inflows into these products have stalled in recent days (not much dip buying). As a result, the VKOSPI to VIX ratio has started to decline and will likely fall further. (2) HF leverage has almost normalized: Swap capacity constraints kept a lid on HF leverage buildup in Korea. Still, L/S ratios in the JPM Prime book rose up to 5.7x. The process of normalization from there is now well advanced. This ratio dropped to 3.2x by 27 Jul, and given the unwind in the Price Momentum factor over 28 and 29 Jul, HF leverage has likely declined further, and not very far from the top end of 2025’s range. (3) Retail leverage through margins less of a risk: Margin balances were never particularly high or witnessing rapid growth. Balances have moderated somewhat to ~$20bn now. And, unlike leveraged ETFs that undergo a process of forced de-leveraging on any spot price declines, margin lending comes with buffers and discretion. Korean retail investors still have ample equity gains, cash balances, higher incomes and overseas assets to tap into to absorb any margin calls should they want to keep the position. (4) Record foreign outflows are slowing: LO selling pressure has substantially eased as Korea (and particularly the memory names) has underperformed, meaning that the two heavyweights are now only 6.5% and 4.5% weights in MSCI EM (vs 9.5% and 8.3% in late June).
- Diversification trades remain in play: We continue to like: (1) “wealth effect” exposures (department stores, cosmetics, travel, brokers, construction) have a compelling tailwind; (2) Bio-pharma is a substantial laggard that potentially benefits from globally improving sentiment around the healthcare sector; (3) Pref share discounts are near record wides – with the resultant elevated yields offering good carry; (4) Banks look particularly attractive with a triple tailwind from improving asset quality with income growth, BOK rate hiking cycle a tailwind for NIMs, and heightened market volumes contributing to brokerage revenues.