Wall Street Warns $1.4 Trillion Margin Debt, Leveraged ETFs Are Emerging as Top US Stock Risk

$1.4 Trillion in Margin Debt and Leveraged ETFs

Emerging as the Biggest Risk to US Stocks

US investors borrowed $1.4 trillion from brokerages to buy stocks

Money flowing into leveraged ETFs doubled in three months

Gains are magnified on the way up, but losses can spiral on the way down

Wall Street warns of systemic risk as the "tail wags the dog"

Wall Street is issuing fresh warnings as borrowing to invest in US stocks has swelled to a record $1.4 trillion. Risk is mounting further as trading in high-risk leveraged exchange-traded funds that aim to deliver two or three times a stock's move grows rapidly.

The Wall Street Journal reported on June 28, citing data from the Financial Industry Regulatory Authority, that margin debt used by US investors to buy stocks reached $1.4 trillion in May. That was up 54% from a year earlier and marked an all-time high.

Investment in leveraged ETFs is also rising quickly. Mark Hackett, chief market strategist at Nationwide Investment Management Group, told the Journal that investors are using margin to buy leveraged ETFs, multiplying risk threefold or fourfold. Assets under management in leveraged ETFs doubled to a record $220 billion between March 30 and June 3, according to FactSet. The largest inflows went into products tied to technology stocks, semiconductor indexes, Tesla, Nvidia and SpaceX. The Journal cited one example in which Micron Technology rose about 300% from late March, while the Direxion Daily Semiconductor Bull 3X Shares gained about 700%. If the underlying stock drops 30%, however, a 3x leveraged ETF can lose about 90%.

The Journal said the risks of leveraged ETF investing were evident in the recent slump in South Korea's stock market. In South Korea, where leveraged bets had piled into large semiconductor stocks, prices swung sharply enough to trigger circuit breakers. The resulting hit to investor sentiment spread to US artificial-intelligence-related shares, the report said.

Leveraged ETFs do more than magnify investor gains and losses, the Journal said. They can also help drive stock prices higher. To deliver double the gain in a stock, leveraged ETF managers buy derivatives such as futures from brokerages and other counterparties. When stock prices rise, managers have to buy more derivatives at that day's close.

Leveraged ETF managers have bought about $300 billion of derivatives since late March, according to Barclays. Financial firms that sold those derivatives then bought the underlying shares to reduce their own risk. That mechanical buying further fueled the rally.

When stocks fall, managers have to sell the derivatives they hold. Financial firms that sold those derivatives also sell shares to unwind hedges. That process can deepen declines and create a vicious cycle.

Alexander Altmann, Barclays' head of global tactical strategies, told the Journal that it would be highly concerning if such large positions had to be unwound over a short period. He called it the biggest non-discretionary risk in the market right now. On June 5, a 3x leveraged semiconductor ETF plunged 31% in a single day, roughly three times the drop in its underlying index.

Investors are also increasingly worried that as leveraged ETFs grow larger, they may stop simply tracking underlying assets and instead begin moving those asset prices themselves. Dave Nadig, research director at ETF.com, said the biggest concern is continued inflows into leveraged single-stock products. As more money buys and sells mechanically regardless of price, market volatility will only increase, he added.

Park Shin-young, New York correspondent, Hankyung.com nyusos@hankyung.com