AI Stock Heavy ETF Risks Spread to Broader Equity Market

Wall Street history is littered with products that got too popular for their own good. Quant strategies smothered by crowding. Mortgage bundles that led to a crisis. Bets against volatility that became the main driver of turbulence. Now, leveraged exchange-traded funds look set to join the list. A dramatic expansion in the issuance and use of these products over the past few years has brought the vehicles — which harness derivatives to amplify, reverse, or reverse-and-amplify the performance of an underlying security — to the point when the risks are no longer contained solely to their own investors. That was emphatically demonstrated in South Korea over the past few weeks, after a frenzy of speculation saw billions of dollars poured into leveraged ETFs tracking two chipmakers, SK Hynix Inc. and Samsung Electronics Co. Those funds initially added fuel to an already powerful artificial intelligence-driven rally, then helped accelerate declines when sentiment reversed. The benchmark Kospi Index, which is dominated by the two stocks, became more volatile than Bitcoin. “There are elements of the growth of levered ETFs that remind me of the meme frenzy,” said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets. “Even for investors who want nothing to do with levered ETFs, it is important to understand that it can still impact them.” A hectic bout of deleveraging in the wake of the Korean drama has cut the total money invested in leveraged ETFs, which even at its peak was small compared to the global equity market. But a Bloomberg News analysis shows how their share of daily trading activity far exceeds their weight in terms of assets, indicating a stronger influence than appearances first suggest. At the same time, most of the cash in play is concentrated in just a handful of AI-related stocks. That makes the relevant metric for influence not the broad market, but the individual liquidity in those shares, and whether the related leveraged products have a footprint large enough to impact available trading. “The scenario that worries me most is a sudden event very close to the close of trading, whether at a company or market level, that would force end-of-day rebalancing activity to happen in a very short period of time,” said Rocky Fishman, founder of Asym Research. AI Focus At first blush, the leveraged ETF industry looks relatively insignificant. While total global assets in the funds hover around $250 billion, that’s a fraction of the more than $22 trillion in all ETFs worldwide. But measured by daily turnover — the amount of fund shares that change hands each day — they are hugely over-represented, making them one of the busiest parts of the fund universe. The gap reflects how the products are used. Money in a conventional ETF may remain invested for years, but because leveraged funds aim to amplify the performance of their underlying index or stock over a single day, traders move in and out of them frequently. Trading volume in leveraged ETFs tripled from its January low to its June peak, with 30-day volume reaching about $70 billion, according to Bloomberg’s analysis. Decomposing that activity and fund assets offers a barometer of sentiment. About $20 billion is currently invested in inverse leveraged ETFs and more than 10 times that amount in their bullish peers, while the average daily turnover for the past 30 days is around $18 billion and $43 billion, respectively. “The more confident investors become, the more they want to amplify the positive returns they imagine ahead,” said Peter Atwater, the president of advisory firm Financial Insyghts. The record use of leveraged ETFs and other options strategies “suggests bullish investors feel all but invulnerable,” he said. The upbeat mood corresponds to the AI-driven stock rally, which is also borne out in where leveraged ETF exposure is concentrating. Analysis of around 800 bullish leveraged equity ETFs shows they are increasingly focused on just a small number of AI names. Funds linked to four major memory-chip makers have seen huge demand, in particular, led by products amplifying the moves of South Korea’s SK Hynix and Samsung. In about a year since launch, those vehicles have quickly become among the largest single-stock leveraged ETFs in the world. It all means that, while the money invested in leveraged ETFs remains modest relative to global equities, fresh inflows are deepening exposure to an already concentrated group of stocks. Many of those names have experienced some of the sharpest swings in years. “What has changed in the past few years is not the overall size of the leveraged ETF market but rather the shift toward leveraged ETFs on volatile underlyings, including the new single-stock leveraged ETF category,” said Fishman. When an investment vehicle aims to deliver two or three times a security’s daily performance, inflows to that product enlarge the exposure that the fund issuer and its counterparties have to maintain — and reset — each session. It also needs to add exposure after the stock rises and reduce it if the stock falls, because the value of the fund changes faster than the position it holds. Somewhat counterintuitively, inverse funds can also be required to trade in the same direction as their underlying security. After a rally, a bearish fund has lost capital while its short exposure has grown relative to the money behind it. To restore its target multiple, it must buy back part of that position. Creations, redemptions, derivatives and the timing of hedge execution can all alter how much trading ultimately reaches the underlying shares. But the bottom line is bullish and bearish products tied to the same stock can rebalance in the same direction. These resets are pegged to the day’s closing price, which concentrates the adjustment into the final minutes of the trading session, alongside index rebalances, options hedging and institutional orders. “The options lingo is ‘short gamma’ but the simple point is that big moves tend to beget other big moves,” Silverman at RBC said. “Any big move of the underlying has a subsequent exacerbating effect.” Nomura Holdings Inc. estimated that at its peak size in June, for every 1% that underlying securities moved, the leveraged ETF complex needed to buy or sell $10 billion worth of securities to rebalance. “The rise of the AUM of leveraged equity ETFs relative to the market cap of underlying equities created unusually large rebalancing flows in recent months, which at times outweigh other flows and amplified market moves thus creating more volatility,” said JPMorgan Chase & Co. strategist Nikolaos Panigirtzoglou. Given the tech bias of the funds, “leveraged equity ETFs will continue to be the source of large rebalancing flows and elevated tech stock volatility,” he said. Korean Volatility Earlier this year, South Korea’s financial regulator allowed the establishment of more than a dozen leveraged ETFs tracking Samsung and SK Hynix, two companies at the heart of the AI revolution that already dominated the Seoul stock market. The move was a response to the billions that Koreans were sending out of the country to similar products that launched in Hong Kong last year. One of the Hong Kong funds, the CSOP SK Hynix leveraged ETF, rapidly became the largest single-stock leveraged ETF in the world with nearly $17 billion in assets at its peak. It became so large relative to the value of shares of SK Hynix that typically trade every day, that investors warned the ETF had begun to move the stock rather than simply track it. With a global rally in AI stocks in full force, the domestic Korean ETFs were also an instant hit, luring more than $9 billion of inflows in two months. While it’s impossible to say for sure how much they contributed to the ensuing volatility, as the Kospi rattled equities worldwide with huge intra-day gyrations, the combined trading of the leveraged funds and their two underlying stocks made up 70% of all daily activity in the Seoul market at the height of the frenzy. The market regulator responded by raising the minimum required deposit for investors in such products and temporarily banning any more from listing. Trading in leveraged ETFs tied to SK Hynix and Samsung shrunk sharply in the wake of the volatility and after the steps to curb demand. To be sure, the funds did not cause the selloff — chip prices, earnings and borrowing costs all played a part in a global wobble for AI stocks. Meanwhile, less visible forces such as hedge funds unwinding their own positions were also likely in play. But by adding so much leveraged exposure to two stocks already carrying most of the Kospi, the funds are seen as a key contributor to the extreme swings that rocked the market. Even with its deep and liquid equity market, the US is not immune to such a phenomenon. Billions of dollars of trades were wiped out in early 2018 when leveraged products tied to the Cboe Volatility Index, known as the VIX, became so large that their rebalancing helped fuel a record jump in the gauge. In 2024, newly launched leveraged ETFs tracking Strategy Inc. were thought to have amplified the already volatile stock after a rush of inflows. “This is how the VIX ETFs blew up,” said Peter Tchir, head of macro strategies at Academy Securities. “They had a mechanical process that was fraught with danger. These products are not as bad, but it is still a concern to me.” Still, not everyone is convinced that leveraged ETFs pose much danger beyond each fund’s own investors. Chris Murphy, co-head of derivative strategy at Susquehanna International Group, says it’s important for users to understand their mechanical trading, but ultimately they’re just a small part of a much bigger puzzle in how markets move. “I don’t spend a lot of time worrying about levered ETFs compared to any of the other risks in the market,” Murphy said. “Leveraged exposure contained in a transparent and liquid ETF is a better understood risk than mystery exposures elsewhere.” Turnover of leveraged ETF shares is suggestive, but on its own it proves nothing about prices. A dollar traded in a fund need not produce a dollar of trading in the stock behind it, since market makers can offset positions internally, hedge with derivatives or match buyers against sellers. While Fishman at Asym Research worries about the impact of leveraged ETFs on certain individual stocks and their potential role in any shock event near the close, he reckons wider concerns are overblown. The products do “have the potential to create feedback loops,” he said, but that’s a well-known effect that has been around a long time. “Their potential rebalancing impact is no higher, economically, than it has been for years,” he said. “Theoretically they could grow to the point of becoming systematically important but we’re far from that point.” Investor Risks The one risk market players can agree on is to investors in the funds. While a product offering two or three times the returns of a big tech company sounds alluring, that promise only holds over a single day. Each fund has a fee drag and must continually pay to reset its positions; meanwhile a phenomenon known as volatility decay means a loss of value occurs over time as an underlying security or market moves up and down. As a result, a leveraged ETF could deliver its promised multiple every session and still leave a long-term holder far short of the return its name appeared to imply. Even an investor who took opposite sides of the same stock would ultimately lose money. That’s why the industry insists the products are tactical instruments designed for daily exposure. Nonetheless, turnover data show that for bullish investors, the average holding period is far above the single day that is recommended. That’s likely down to the general positive trend of the market, which means they’re less likely to feel the fee drag and volatility decay. Regardless of the ongoing costs of a fund, staying invested carries a simpler risk, as events in Korea have demonstrated. A market trend or stock’s performance can quickly turn, and when it does the losses in a leveraged product accumulate fast. The higher the leverage, the quicker an investor can be wiped out. It’s one reason why in the US, rules were put in place to limit the amount of risk a fund can take, which has effectively capped new products to offering maximum leverage of twice the underlying. While a few three-times ETFs exist for legacy reasons, regulators recently pushed back on attempts to launch new funds at three-times or above. Silverman at RBC says the ease with which money can be made or lost adds an extra risk to leveraged ETFs: a reaction function among the broader investor base. “The ‘tail that wags the dog part’ is that there is human emotion layered on top of that, particularly if the ETF is heavily owned by retail,” she said. “So, an up day exacerbates the FOMO and YOLO that creates more positive momentum. But a down day exacerbates the fear that can create panic selling.”