I like to kick off articles with a question, and there’s no question I enjoy asking more than the one which asks, rhetorically, how many times I’ve mentioned something which eventually became a mainstream financial media obsession.
Here’s the question: How many times have I warned, over the last six or so months, that leveraged ETFs and, more recently, leveraged ETFs referencing semis and particularly South Korea’s national chip champions, are straining market structure precisely because they’re reshaping it in real time?
The answer’s “a lot.” I’ve penned so many leveraged ETF pieces I couldn’t make an exhaustive list if I tried. And true to form, mainstream outlets are catching up — because a handful of people at those outlets are among my cult following. (“They walk among us!”)
As alluded to above, this discussion (about the leveraged ETFs, not about me pretending to impact Bloomberg editorial trends) took on a new sense of urgency in June, when it became apparent that levered retail products linked to Samsung and SK Hynix were distorting the price action. In those two names yes, but given their market cap, in South Korean equities more “broadly” too (the scare quotes are there to remind you that Samsung and SK Hynix are ~60% of the index).
Now, according to SocGen, leveraged ETFs may be impacting the cost of equity funding. Have a look at the figure below, from Jitesh Kumar.
Never before has the cost of leverage, when accounting for seasonality, been this high.
As Kumar noted, that’s not asset managers. Yes, their net longs in S&P futs rose by a third from end-March through mid-May, but the cost of funding was mostly unchanged over that period. Those positions actually came off — albeit not by a lot — during the big spike in funding costs.
That leaves, among other cohorts, retail investors, whose participation continues to rise. And who, pray (or maybe “prey” is more apt here) tell, are leveraged ETFs marketed to? Retail investors.
“The excitement towards leveraged ETFs helps reconcile this,” Kumar said, adding that ballooning AUM in those products “could have been meaningful enough to quickly run up against balance sheet constraints at banks.”
The figure on the left’s a reminder: AUM growth’s exponential in these products. The figure on the right hints at a relationship with the cost leverage.
Some of you will surely say this is intuitive and therefore obvious. As Nomura’s Charlie McElligott noted last month while explaining an explosion in SK Hynix call volume, “I think leveraged ETFs are increasingly needing to participate in options for leverage, as their traditional financing lines max out.”
Kumar spelled it out further. “If some of the leverage in this corner of the market is being offered by banks for quite high remuneration, then the cost of funding would have been impacted from this additional source of equity-specific demand, which is competing with the classic sources of balance sheet demand,” he wrote, adding that because banks can only grow equity leverage capacity slowly, rising leverage costs should “acts as a self-limiting mechanism.”
Of course, this leverage has to be obtained from somewhere if the semi rally / AI trade keeps going (remember: something like nine out of every 10 AUM dollars in those leveraged ETFs is concentrated in chips and tech) and the AUM in those products keeps rising. The more pressure there is in that regard, the higher “the instability risk,” as Charlie put it.
