How Leveraged ETFs Turned South Korea’s Stock Market Into a Casino and Why the U.S. Might Be Next

The recent stock market selloff in South Korea has left investors reeling, with the country’s benchmark KOSPI index plummeting by 44% from its June peak before staging a record-breaking rebound on Friday. Beneath this volatility lies a more ominous trend: the proliferation of leveraged exchange-traded funds (ETFs) that has led to estimated losses of $38 billion for retail investors.

The rise of these leveraged ETFs is symptomatic of a broader issue – the increasing reliance on debt-fueled investment strategies in an environment where stock prices are already elevated. Investors are being tempted into high-risk trades that promise outsized returns but carry significant downside risk. In South Korea, single-stock leveraged ETFs accounted for 70% of total daily trading volume by July.

Over a million retail investors held positions in these leveraged ETFs, with margin calls delivered on more than 1.2 million citizens – approximately 3.4% of the adult population. This is starkly different from the 1-5% of U.S. retail accounts that hit margin triggers during the entire 2008 global financial crisis.

This is not just a South Korean problem; it’s a warning sign for global markets. The surge in leveraged ETF assets under management in the U.S. has been spectacular, reaching a record $218 billion since March. While they may only account for 1% of total ETF assets, they now generate 40% of all U.S. ETF trading volume.

The dangers of leverage are well-documented. As Charlie Munger warned, “Leverage strips away an investor’s most important asset: time.” Unleveraged investors can ride out cyclical downturns with ease; leveraged traders get liquidated at the absolute bottom, right before the recovery takes off.

Several factors contribute to this trend. The desperate bid for returns in a low-yield environment has led investors to take on increasingly high levels of risk. Additionally, social mobility has become tied to high-leverage bets on tech giants like Samsung and SK hynix in South Korea. These investments became viewed as a ticket to social mobility – or so it seemed.

For American investors, the warning signs are clear. The proliferation of leveraged ETFs is not just a domestic issue; it’s a global phenomenon that threatens to unleash chaos on markets around the world. As we watch South Korea struggle to contain the fallout, one thing is certain: investors would do well to take heed of this cautionary tale.

The impact of this crisis will be felt far beyond the borders of South Korea. Regulators in other countries should take notice – and act accordingly. National Assembly member Lee Jong-wook’s warning that “the country has turned into a casino” is a clarion call for investors everywhere: beware the allure of high-risk, high-reward trades.

While we can’t predict with certainty when this bubble will burst, one thing is clear: investors would do well to incorporate the possibility of a similar fate into their investment process and risk management approach – not as an option, but as a necessity. As the saying goes, “history doesn’t repeat itself, but it does rhyme.” The parallels between South Korea’s crisis and past financial contagions are too striking to ignore.

It’s time for investors to take a hard look at their own portfolios and ask themselves: am I vulnerable to this kind of scenario? Can I ride out the storm when – not if – the music stops? Unfortunately, the answer is far from certain. But one thing is clear: investors would do well to heed the warning signs emanating from South Korea’s stock market selloff – before it’s too late.