Debt Binge Drives Stocks Into Risky Territory

BY JACK PITCHER

Investors have never been more eager to ratchet up their stock returns through margin loans and funds that amplify gains and losses. It may be a sign of trouble.

U.S. margin debt, or what investors borrow from their brokerages to buy securities, rose 54% to a record $1.4 trillion in May from a year earlier, according to Finra data. Meanwhile, high-risk leveraged exchange- traded funds that produce double or triple the daily move of underlying stocks are growing rapidly, as is

trading in options tied to them.

The risks surfaced last week in South Korea, a market dominated by highflying semiconductor stocks and rife with investors eager to pile on leverage. Korean stocks gyrated, triggering circuit breakers meant to stop losses on the way down. As the souring mood spilled into U.S. trading, hitting AI-related stocks, a chorus of investors and ana-

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lysts sounded the alarm that leverage was building up here, too.

“I’m fearful that we’re building unintended leverage that isn’t fully understood,” said Mark Hackett, chief market strategist for Nationwide’s investment management group. “You’ve got people with a lottery mentality using margin to buy options on levered ETFs. That’s three or four layers.”

Buyers ranging from hedge funds to teenagers on Robinhood have poured money into leveraged ETFs this year, helping to nearly double the assets in these funds to a record $220 billion between March 30 and June 3, according to FactSet.

The most popular leveraged- fund offerings are tied to indexes of technology and semiconductor stocks, as well as individual companies like Tesla, Nvidia and, most recently, SpaceX.

At a time when investors large and small appear to have limitless appetite for these megacap tech stocks, the funds have obvious appeal: Why own shares of Elon Musk’s SpaceX when one can now buy into a single-stock fund that offers twice the exposure? And the sizzling chip rally that lifted Micron Technology by 300%? Not bad. But what about Direxion’s 3X Bull Semiconductor ETF, which soared some 700% between late March and late June?

The risks of buying leveraged funds are well-advertised: A 30% drawdown in the underlying stock can turn into a 90% wipeout for the fund. But Wall Street sees a broader problem emerging: These funds, along with other forms of leverage, can and do have an effect on the way the individual stocks behave. The recent action in South Korea, market participants said, offers a glimpse at the risks.

To keep pace with the flow of new money, leveraged funds have bought some $300 billion in derivatives linked to single stocks and indexes since the end of March, Barclays analysts estimate.

Those purchases have in turn spurred demand for underlying shares from market makers, which buy stocks to hedge their exposure to the derivative contracts they write.

That has almost certainly contributed to the sharp gains in corners of the stock market this year. But when stocks fall, leveraged funds lose assets. That forces them to reduce exposure to the shares they track, which in turn threatens to pull down stock prices even more. There is a danger, market analysts said, that this cycle can quickly spiral into heavy losses.

“That’s a somewhat terrifying figure to contend with should it need to be unwound in a short period of time,” Alexander Altmann, global head of equities tactical strategies at Barclays, told clients. “This is without a doubt the largest nondiscretionary driver of risk at the moment.”

Leveraged ETFs allow nearly anyone with a brokerage account the chance to supercharge their exposure to a stock market that has been posting gains not seen since the dot-com bubble a generation ago. But what goes up fast can crash even faster.

On June 5, for example, the popular 3X semiconductor fund plunged 31% in a single session, roughly tripling its benchmark index’s decline, as intended.

If a leveraged fund grows large enough, it can start to have a significant impact on an underlying stock it is tied to, a phenomenon traders refer to as “the tail wagging the dog.”

As stock volatility has increased, especially in sectors like semiconductors that have heavy leveraged-fund and options activity, analysts have started to scrutinize the role leverage is playing.

Geopolitical risks and the potential for rate increases have unnerved investors recently and could spark more volatility this week after the U.S. and Iran traded attacks over the weekend. June jobs report data that could affect rate decisions are set for release Thursday.

“I am genuinely worried we have so much money going into the complex of leveraged single-stock products because the more money that goes in there, the more this procyclical trading effect happens,” said Dave Nadig, an industry veteran and director of research at ETF.com. “Anytime you have any known in-advance, priceindiscriminate buyers and sellers, you have a problem.”

Trading related to massive leveraged funds tracking popular South Korean stocks like Samsung and SK Hynix composed as much as half the average daily volume in those stocks in recent weeks, exacerbating share-price moves in either direction.

South Korea’s top financial regulator said last week that he regretted not blocking the launch of leveraged singlestock funds.

“These are high-risk products, and it seems like about 92% of holders are retail investors,” Financial Supervisory Service Gov. Lee Chan-jin said in a press briefing. “Despite consumer warnings, trading hasn’t cooled.”

There is no equivalent situation in the U.S. because the funds are smaller compared with the stocks they track, but investors should be mindful, Nadig said.

In the U.S., one of the largest brokerage firms just moved to rein in client leverage. Charles Schwab, which lets some customers buy securities with margin loans secured by the assets in their account, alerted advisers earlier in June that it was tightening margin requirements and would issue margin calls to investors that exceed new thresholds, Bloomberg reported.