The Trillion-Dollar Borrowing Binge Lifting the Stock Market to Risky Heights
Leveraged funds and margin debt have grown to unprecedented levels this year
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 this past 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 analysts 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.
As investors large and small pile into megacap tech stocks, the funds have obvious appeal: Why own shares of Elon Musk’s SpaceX when a single-stock fund offers twice the exposure? And the sizzling chip rally that lifted Micron Technology by 300%? Impressive. 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 also affect how the individual stocks behave. The recent action in South Korea, market participants said, offers a glimpse at the risks.
In a bid 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’s 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 on Wednesday. “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 down 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 the underlying stock to which it is tied, 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 heading into the weekend. The June jobs report, which could affect Fed rate decisions, is 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, price-indiscriminate buyers and sellers, you have a problem.”