Average allocations to South Korea by active global emerging market funds rose sharply over 18 months but flattened in June, as volatility spiked, figures from analytics firm EPFR show.
"In Korea, we believe the leveraged ETF unwind is complete and hedge funds are ~90% through deleveraging — back to acceptable levels," according to J.P. Morgan analysts led by Rajiv Batra, head of Asia and co-head of global emerging markets equity strategy.
"If a durable bottom forms here, history is supportive," they said in a note in July, with the median 12-month return after previous emerging-market corrections being about 28%.
Leverage has been at the forefront of South Korea's sparkling rally and stunning reckoning because, via products such as single-stock leveraged exchange-traded funds, it has transformed the market and jacked up volatility.
The rally that more than tripled the value of the KOSPI .KS11 benchmark over the 12 months to June's peak hit overdrive after single-stock leveraged ETFs launched in South Korea in May and they exacerbated the slide from the highs.
"Long only investors just don't want to have to manage positions in stocks which are moving as violently as these stocks are moving," said William Brattan, head of cash equity research for APAC at BNP Paribas.
The extremely sharp drop led to a public apology from South Korea's Finance Minister Koo Yun-cheol for introducing these ETFs without careful consideration, and new measures to rein in the leveraged products.
Citi's trading strategies desk estimated last week total losses for retail investors in leveraged ETFs at around $38.7 billion, a factor in mounting anger directed at policymakers for allowing single-stock leveraged funds to launch.
"The amount of money that went into SK and Samsung was staggering," said Pierre Hoebrechts, deputy CIO at East Eagle Asset Management.
"The number of accounts opened in Korea, combined with local leverage and very concentrated exposure, with the cherry on the cake being large 2x-levered foreign ETFs, just made it an accident waiting to happen."
Hoebrechts said his firm had been short, or betting on falls in the KOSPI and Japan's Nikkei .N225 since the end of June, but squared off its positions last week, believing the washout phase may be nearing an end.
Average short interest, weighted by positions' value, for South Korea is about 4.3%, down from a recent peak of about 5.3%, according to data from S3 Partners.
To be sure, there are plenty of risks remaining, and for many, Friday's record-breaking 17.9% surge in the KOSPI was just as unsettling as some of last month's sharp falls. The index fell nearly 5% on Monday.
But, said Larry Hatheway, head of research at Franklin Templeton Institute, U.S. institutional investors, while wary of stepping into a falling market, "may be willing to take another look at some of these (Korean) names now."
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