Insight: South Korea's retail investors make market waves

HONG KONG (Reuters) - Henry Seggerman has spent two decades investing in South Korea and over the years he has seen his fair share of market quirkiness. But when he heard about the princes and princesses, he was amazed.

Seggerman, who is chief investment officer of International Investment Advisors, has been closely following the latest investment craze in South Korea -- wrap accounts. Over the past year, they have become a dominant and sometimes dangerous force in the Korean equity market, adding fuel to a sell-off this month that could become the biggest on record.

The accounts pool money from retail investors and high net worth individuals and are known for quick, sharp bets concentrated on the country's biggest stocks, such as Hyundai Motor (005380.KS) and Samsung Electronics (005930.KS) -- the princes and princesses.

Partly because mutual funds lost their lustre after a poor performance during the 2008 financial crisis, the lightly regulated wrap accounts have soared in popularity. Now they have become toxic for the Korean market, and their impact has even hit other Asian markets such as Hong Kong's Hang Seng .HSI.

As the darlings of the Korean market kept rising -- flagship companies of the country's giant family-run conglomerates like Hyundai and Samsung -- Seggerman asked one top brokerage executive whether the valuations being put on some of these stocks were sustainable.

He said the reason valuations on "the princes and princesses" were so great is that everyone is enamored with them, and so their prices can only keep going up.

"It reminded me of that guy in 1929 who said stocks have reached a permanently high plateau," said Seggerman, referring to the infamous remark made by economist Irving Fisher on the eve of the 1929 Wall Street crash.

Wrap funds give clients market performance on an almost real-time basis, but that means investors in them tend to bolt as a herd, causing fierce share price swings.

Korean car makers were a clear favorite for wrap accounts earlier this year, particularly after the devastating March 11 earthquake and tsunami when they were seen capturing market share from Japanese peers.

By April and May, Hyundai Motors and Kia Motors (000270.KS) -- the No. 2 and No. 4 companies by market cap on the KOSPI -- were trading at all-time highs, up more than 60 percent and 40 percent on the year, respectively.

That helped drive the benchmark KOSPI index .KS11 to a record level as well. When the global equity sell-off began at the start of August, the slide in South Korea was particularly precipitous due to the impact of wrap accounts and their stampeding characteristics.

BATTERED KOREA

The KOSPI's almost 17 percent plunge this month has outpaced the rest of the region on much sharper intraday swings, including a nearly 10 percent one-day plunge that sent authorities scrambling to take measures to help stem the slide. They issued a three-month ban on short-selling, amid persistent talk the country's pension fund would start buying stocks to help support the market.

Seoul shares gained ground on Thursday with the fairest princess of them all, Samsung Electronics (005930.KS), up more than 3 percent.

While traders and analysts say wrap accounts have been a key factor in fueling market volatility, little attention has been given to them beyond a few local media reports.

Some believe it is time for authorities to take a closer look at the lightly regulated funds and their strategies, not least because of some of their more aggressive bets involving structured products based on other Asian indices could have had an exaggerated impact in the Korean market due to margin calls.

"Korea has an investment culture that tends to be herding oriented. A successful strategy tends to get replicated and gets overdone," said Shaun Cochran, head of Korea research at CLSA who has closely followed the evolution of wrap accounts.

The problem with wrap accounts is their inherent strategy of concentrating on just a handful of stocks, he said.

"These funds pick stocks that they like and they pick them well. You have to respect their stock-picking abilities. But clients can see them changing positions and try to replicate. So as soon they start selling something it gets crushed," Cochran said.

Wrap accounts have now started to increase the cash weighting in their portfolios. One of the largest advisors, Brain Investments, increased its cash weighting to 25 percent from 10 to 15 percent earlier in the year, local media reports said.

Brain Investments' chief executive Park Gun-young did not return a call seeking comment. Korea Creative Investment (KCI), run by former Mirae Asset Global portfolio manager Seo Jae Hyeong and a leading purveyor of wrap accounts, declined to comment for this story.

ADVISORY WRAPS

South Korean investors, nursing wounds after the 2008 financial crisis, had soured on mutual funds, particularly installment equity funds, in which clients put aside a fixed amount of money every month at banks to be invested in stocks.

It proved to be a great opportunity for a new kind of financial service known as advisory wrap accounts, run by brokers with advice from outside firms such as KCI or Brain who play the role of investment consultants.

The slow development of the Korean hedge fund industry has aided their popularity, since it has given investors a highly customizable alternative to traditional mutual funds.

According to Samsung Securities, balances at wrap accounts rose to just over 45 trillion Korean won at the end of July, more than double the 20 trillion Korean won ($18 billion) they managed at the start of 2010.

Wrap accounts have only one annual management charge -- hence the name because all expenses and commissions are wrapped into a single fee -- and unlike mutual funds have far more flexible and extensive mandates.

Since the fee structure is unrelated to trading frequency, wrap accounts can engage in swift short-term bets sometimes with time horizons of a few days.

Some used highly leveraged structured products, mainly by taking risky positions selling put options on the futures of other Asian stock indexes, particularly Hong Kong's Hang Seng and the China H-share index.

By selling puts, investors take a leveraged bet that stocks are going to keep rising, but losses can pile up quickly in a plunge.

With fears of a China slowdown growing over June and July the premium on 'put' options on the benchmarks became more expensive. Such an option gives the buyer the right to sell the underlying at a fixed price at a later date.

A derivatives trader in Hong Kong who trades hybrid products at an Asian bank said some of the Korean wrap accounts, who remained bullish on China, took the opportunity to write, or sell, puts with what are known as "knock-out" clauses.

In such a contract, the option is nullified and the put writer keeps the premium if the underlying security hits a particular level. However, if the security drops, the put writer records mounting mark-to-market losses and would need to post margin, or a cash reserve, with the broker.

When the sell-off in Asian markets intensified, those mark-to-market losses deepened, prompting margin calls and urgent cash requirements. The Korean investors met those cash calls by dumping shares in the local Korean market thus exacerbating the plunge.

THE NEXT BIG THING

Wrap accounts are certainly not unique to Korea. Most developed markets have similar investment options, although some go by different names.

Australia, Japan and Britain have these kinds of accounts but provide more regulatory oversight. Moreover, their overall impact is limited because those markets are deeper and larger.

The United States is a different story and perhaps a warning of the risks ahead for an industry that has experienced explosive growth in Asia.

The U.S. Securities and Exchange Commission declared "wrap accounts" illegal in 2007. Ten years earlier the SEC had, in fact, encouraged brokerages to offer wrap accounts that "better align the interests of brokers and clients."

The decision to ban them then was the result of a prolonged legal wrangle over an SEC rule that exempted certain brokers who offer investment planning advice from strict disclosure requirements, as long as the advice was only a small part of their business.

Wrap accounts could come under similar scrutiny in South Korea if the market continues to wallow. "I wouldn't be surprised if the regulators took a look at this and said this is silly," said IIA's Seggerman.

Earlier this year, the Financial Services Commission in Seoul banned investment advisors from promoting products that guaranteed a certain return.

"We are remaining vigilant on wrap accounts and brokerages' over-promotion or wrong information about these products to attract more clients," said a senior regulatory official who declined to be identified.

Regardless of whether the allure of wrap accounts fades, market experts say South Korean investors will most likely latch on to the next big thing.

"What Korea has is this amazing ability to reinvent itself. But the ability of the market to make the same mistake each time is equally astounding," CLSA's Cochran said.

"It was 'buy Korea funds' in the 2000 cycle; it was the installment equity funds in the 2007 cycle, and it's the wrap accounts in the 2011 cycle. My guess is the next cycle will be hedge funds," he said.

($1 = 1087.450 Korean Won)

(Additional reporting by Ju-min Park in Seoul; Editing by Bill Tarrant)