Since last year, the domestic stock market has been strong and the market capitalization and net asset value of domestic exchange traded funds (ETFs) have surpassed 400 trillion won. In just ten months, the ETF market has more than doubled in size. While ETFs have been a driving force behind the rise in the domestic market, concerns are emerging that, as they grow too large, a ‘tail wagging the dog’ effect could end up shaking the indexes themselves. In particular, as retail investors concentrate on leveraged ETFs that target double the returns, they need to be cautious because losses can be further magnified in downturns.

On the 16th, the KOSPI closed at 6,226.05, up 134.66 points (2.21%) from the previous session. It broke above the 6,200 level for the first time since the war.

With the upward trend continuing from the previous day, as of the 15th the net assets and market capitalization of domestic ETFs came to about 404 trillion won, surpassing 400 trillion won. They crossed 200 trillion won on June 4 last year and 300 trillion won on January 5 this year in quick succession, showing unstoppable momentum.

The sharp expansion of ETFs is the result of a strong rally in the domestic market led by semiconductors and investors jumping into ‘the domestic market’ via ETFs. From the second half of last year, when the domestic bull run began in earnest, through today, the KOSPI has doubled (102.7%) and the KOSDAQ has risen 48.8%, which in turn has greatly swelled the market cap of ETFs holding domestic stocks and indexes.

Retail investors’ net purchases of ETFs were 6.732 trillion won in the third quarter of last year, 16.66 trillion won in the fourth quarter, and 33.013 trillion won in the first quarter of this year, roughly doubling each quarter.

In the past, domestic ETFs tracking US indexes, known as ‘K-SPY’ and ‘K-QQQ’, ranked among the top in retail net buying, but this year the top three have been ETFs tracking the KOSPI and KOSDAQ: KODEX KOSDAQ 150 (2.6284 trillion won), KODEX 200 (2.0188 trillion won), and KODEX KOSDAQ 150 Leveraged (1.784 trillion won). The ETFs with the highest average daily turnover this year were also KOSPI leveraged and inverse products.

Analysts also say that strong demand for ETFs in the retirement pension market recently has played a role. Nam Yong-su, head of the ETF division at Korea Investment Trust Management, said, “Demand for investment products in the semiconductor sector is continuing,” and added, “As ETF investment has increased in defined contribution (DC) retirement plans and individual retirement pensions (IRP), the market has grown rapidly.”

Some also warn that as ETFs have grown so large, they could actually amplify volatility in the domestic stock market.

The share of average daily ETF turnover in the domestic market’s average daily turnover rose from 26.3% in June last year to 45.4% last month. This year, retail investors’ net ETF purchases (about 32 trillion won) also exceeded net purchases of individual domestic stocks (11 trillion won) by 21 trillion won.

Because ETFs bundle many stocks into a single basket, the larger the inflows into ETFs, the stronger the tendency for the index constituents included in them to move together all at once. In principle, an ETF should track the prices of its underlying assets, but as trading in index trackers and other ETFs increases, managers must mechanically buy more of the stocks included in the index, and that buying pressure pulls prices up further. Conversely, when the index falls and investors sell ETFs, managers must sell the index constituents in one go, increasing volatility.

In particular, for leveraged ETFs that are popular with domestic investors, concentration is greater and turnover is higher, so when the market moves sharply they can jolt the entire index.

In its April Global Financial Stability Report released on the 14th (local time), the International Monetary Fund (IMF) stated, “Reports indicated that leveraged ETFs partly contributed to the excessive sell-off in which the KOSPI plunged 12% in a single day early in the Middle East conflict,” and cautioned, “The expansion of leveraged ETFs can amplify market capitulation.”