Key Takeaways:
The stock market's record run is being built on borrowed money — and that borrowed money is building on itself.
U.S. margin debt rose 54% to a record $1.4 trillion in May from a year earlier, according to Finra data, as investors from hedge funds to retail traders ratcheted up leverage to chase gains in AI-linked stocks. High-risk leveraged exchange-traded funds that produce double or triple the daily move of underlying stocks have nearly doubled their assets to $220 billion since late March, FactSet data show.
"I'm fearful that we're building unintended leverage that isn't fully understood," said Mark Hackett, chief market strategist at 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."
The most popular leveraged-fund offerings track indexes of technology and semiconductor stocks, as well as individual companies including Tesla Inc., Nvidia Corp. and SpaceX. The Direxion 3X Bull Semiconductor ETF soared about 700% between late March and late June, far outpacing the 300% gain in Micron Technology Inc. over the same period. But the risks are equally amplified: on June 5, that same fund plunged 31% in a single session, roughly tripling its benchmark index's decline as designed.
Barclays Plc analysts estimate leveraged funds have purchased about $300 billion in derivatives linked to single stocks and indexes since the end of March. Those purchases have spurred demand for underlying shares from market makers, which buy stocks to hedge their exposure to the derivative contracts they write — a dynamic that has almost certainly contributed to the sharp gains in corners of the stock market this year.
"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."
The risks surfaced dramatically 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 halt losses on the way down. Trading related to massive leveraged funds tracking popular stocks like Samsung Electronics Co. and SK Hynix Inc. accounted for as much as half of the average daily volume in those names in recent weeks, exacerbating share-price moves in both directions.
South Korea's top financial regulator said he regretted not blocking the launch of leveraged single-stock 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 at a press briefing.
In the U.S., Charles Schwab Corp. moved to rein in client leverage earlier this month, tightening margin requirements and issuing margin calls to investors who exceeded new thresholds, Bloomberg reported.
When stocks fall, leveraged funds lose assets, forcing them to reduce exposure to the shares they track — a cycle that can quickly spiral into heavy losses. With the U.S. and Iran trading attacks around the Strait of Hormuz heading into the weekend and the June jobs report set for release Thursday, the potential for a volatility spike that triggers forced deleveraging is rising.
"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,'" said Dave Nadig, director of research at ETF.com. "Anytime you have any known-in-advance, price-indiscriminate buyers and sellers, you have a problem."
The Bank for International Settlements warned Sunday that the five largest hyperscalers are on course to devote more than $1 trillion to AI-related capital expenditure in 2025 and 2026, threatening a sharp reversal that could tip some economies into recession if AI-driven investment spending proves excessive.
This article is for informational purposes only and does not constitute investment advice.
