Korea urged to tighten risky ETF rules

Shin Sung-ho
The author is a former CEO of IBK Investment & Securities and a member of Reset Korea Economic Committee at the JoongAng Ilbo.

The stock market descended into chaos from late June onward. Between June 22 and July 30, the benchmark Korea Composite Stock Price Index (Kospi) plunged 38.6 percent, accompanied by violent day-to-day swings that left investors in despair. A collapse of such magnitude appears unprecedented since the 1962 stock market turmoil. Over the same period, stock markets in six major Western economies moved between a decline of 0.5 percent and a gain of 4.4 percent.

The sell-off was initially triggered by foreign investors’ stock sales and vague fears that the semiconductor cycle had peaked. But the securities industry and financial authorities helped make matters worse. The industry’s excessive optimism first led to a serious misstep. Brokerage firms had forecast in June that the Kospi would rise well above 10,000. It was against this backdrop that single-stock leveraged ETFs were launched. Investors came to regard these products as a magic wand for multiplying their wealth.

To be sure, the products carried risk disclosures. But those warnings were largely drowned out by the securities firms’ overwhelmingly bullish forecasts. Many investors went so far as to borrow money to buy the products. Funds that had previously been spread across other stocks also poured into Samsung Electronics and SK hynix, two companies that together account for more than half the total market capitalization of Korea’s stock market. The securities industry and regulators, in effect, helped create precisely the kind of all-in investment — and the sharp contraction in demand for other stocks — that should never have been allowed. The subsequent plunge in the two semiconductor giants’ share prices then cascaded into a market-wide rout.

Global investment banks such as Goldman Sachs now favor Korean equities more than any other market in the Asia-Pacific region, citing the country’s strong growth prospects and relatively low valuations. Major investment institutions including Fidelity International and Federated Hermes also view Korean stocks favorably because of attractive valuations and solid earnings prospects. Morgan Stanley recently projected that the Kospi could reach 9,000.

Yet global investors remain concerned that volatility in semiconductor stocks could return, even after the unwinding of highly leveraged investments associated with Leopold Aschenbrenner, the Wall Street AI wunderkind. Volatility originating overseas in the semiconductor sector may be beyond our control. But volatility generated at home should be contained. Measures reportedly under consideration include introducing variable leverage and raising the minimum investment amount for ETFs further. They should be implemented without delay. Dragging our feet could invite unforeseen risks.

This is also an opportunity to address broader shortcomings.

First, the securities industry must adopt a more responsible posture. For every new product, firms should promptly disclose all foreseeable risks as well as potential opportunities. They should also state explicitly whether the overall balance of risks and opportunities is genuinely in the investor’s interest.

Second, product proposals should compare the historical performance of identical or similar products, not only those offered by the issuer but also those of competitors. They should provide detailed performance data under both rising and falling market conditions. This is particularly important when selling highly volatile investment products. Investors should be shown how a product performed when prices temporarily declined during an overall uptrend, or temporarily rose during a downtrend. Projections for the product’s future prospects should also be provided.

Third, asset managers and distributors should refrain from selling products whose risks they themselves find difficult to assess. The legal implications of the leveraged products involved in this episode also warrant examination. Above all, regulators and the industry should determine whether the risks associated with these products were adequately scrutinized in the first place. It is worth asking whether simply notifying investors of those risks can really be regarded as sufficient fulfillment of a firm’s duty to assess and manage them.

Financial authorities, too, should reflect on their role and improve the system. They should first refrain from policies that depart from basic principles. Introducing single-stock ETFs in an effort to encourage so-called Seohak ants, or Korean retail investors investing in overseas stocks, to help address the won’s weakness was a departure from market fundamentals. Exchange-rate stability ultimately depends on improving the conditions in which companies conduct economic activity and thereby raising growth. Every policy challenge should be addressed according to sound first principles.

Fourth, operating plans for high-risk products should include flexible responses to changing market conditions. Firms that launch or sell risky products should also invest a certain amount of their own capital in them, sharing the risks with investors. Depending on the product, authorities should consider requiring that losses first be deducted from the issuer’s or distributor’s invested capital, with investors bearing losses only afterward.

Finally, if losses from a newly launched product become excessive, securities authorities should restrict the company from introducing similar products in the future. Those responsible for the product should also be barred from managing related products.

Without even these minimum safeguards, it will be difficult to manage risks in an industry where the lure of profit can easily overwhelm prudence.