Foreign Capital Returns to Taiwan and Korea, Funds Increase Holdings in China and India, Beware of Leveraged ETFs Amplifying Volatility

Overview

This weekly capital flow monitoring report published by Goldman Sachs focuses on tracking cross-border capital flows, mutual fund position changes, and retail investor behavior in global and emerging markets. The core conclusion indicates that although foreign capital has been generally flowing out of Asia-Pacific markets excluding China year-to-date, there was a significant return this week, mainly due to strong buying in the Taiwan and Korean markets. In terms of asset allocation, mutual funds noticeably increased exposure to China and India in May, while reducing holdings in Korea and Brazil. The report specifically warns that the rapid expansion of leveraged ETF sizes and record-high margin balances in the Korean and Taiwanese markets are creating a structural environment where market makers' Gamma rebalancing operations may mechanically amplify daily price fluctuations, especially in the Korean market.

Core views

Regarding foreign capital flows, Asia-Pacific emerging markets excluding China received $5.7 billion in net inflows from foreign institutional investors (FII) this week, with Taiwan contributing $3.3 billion and Korea contributing $1.7 billion. Non-Asian emerging markets also recorded a small net inflow of $250 million, mainly driven by Brazil. However, year-to-date data shows that cumulative net foreign outflows from Asia-Pacific markets excluding China have reached $121.8 billion, with Korea leading with net outflows of $76.4 billion and India with net outflows of $29.8 billion. In contrast, Japan is the Asian market with the most foreign buying this year, with cumulative net inflows of $62.9 billion. In terms of mutual fund allocation, based on preliminary EPFR data for May, Global Emerging Markets (GEM) funds are most overweight in Brazil and Mexico, while being most underweight in Taiwan. Over the past month, fund managers have significantly increased exposure to China and India, while reducing positions in Korea and Brazil. At the sector level, capital flowed out of the Korean tech hardware/semiconductor sector into the industrial sector; in China, capital rotated from the industrial sector to the banking sector. Leveraged ETFs and market volatility risk are one of the focal points of this report. The assets under management (AUM) of Korean leveraged ETFs have risen to a peak range of $40-47 billion, with leveraged exposure accounting for 1.4% to 2.6% of the market's free-float market cap. Since nearly half of the notional amount comes from offshore registered products, cross-border rebalancing flows are further amplified. The report points out that market makers' Gamma rebalancing is pro-cyclical; on days of significant volatility in the Korean market, their trading volume may exceed 20% of the average daily turnover, thereby exacerbating the dynamic of "panic selling during declines and chasing highs during rallies." Although the size of Taiwanese leveraged ETFs has also grown to approximately $9-10 billion, they account for only 0.5%-0.6% of the free-float market cap and are mainly domestically issued, so their rebalancing flows impact less than 2% of daily turnover, far lower than in Korea. Regarding Southbound Capital (Stock Connect), there was a net outflow of $600 million this week, but year-to-date cumulative net inflows still stand at $38 billion. This week, Southbound capital mainly bought stocks such as Kingboard Laminates, Kingboard Holdings, and Knowledge Graph Technology (Zhipu), while mainly selling Alibaba, Tencent, and CNOOC.

Analysis framework

The report adopts a multi-dimensional capital flow analysis framework. First, by tracking the weekly and year-to-date cumulative net flows of foreign institutional investors (FII), it distinguishes capital movements across different regions (such as Asia-Pacific ex-China, non-Asian emerging markets) and specific countries (such as Korea, Taiwan, China, India, Brazil) to judge short-term sentiment and long-term trends. Second, it uses EPFR data to monitor changes in asset allocation of global and emerging market mutual funds, including country-level overweight/underweight (OW/UW) ratios and monthly changes, as well as sector-level rotation, to gain insights into strategic adjustments by institutional investors. Finally, the report introduces a microstructure perspective, focusing on analyzing the assets under management of leveraged ETFs, option implied volatility, and margin balances, combined with the market maker Gamma rebalancing mechanism, to explain the internal logic of amplified market volatility, and compares the differences between Korea and Taiwan regarding this structural risk.

Methodology notes

• Quantitative/Factor/Portfolio Theory

  Dealer Gamma Rebalancing

  Refers to hedging transactions conducted by option market makers to maintain Delta neutrality as the underlying asset price changes. When leveraged ETFs are prevalent, this mechanical rebalancing forces market makers to buy more when the market rises and sell more when it falls, thereby amplifying market volatility.

• Event Gaming and Behavioral FinanceCapital Flow/Chip Analysis

  Capital Flow/Chip Analysis

  By monitoring the net buying and selling of foreign capital (FII), Southbound capital, mutual funds, and retail investors, it analyzes changes in the distribution of market chips and the movements of major capital, thereby judging short-term market pressure and long-term support.

• Company Fundamentals and Financial Framework

  Overweight/Underweight Analysis

  Compares the difference between actual fund holding weights and benchmark index weights; positive values indicate overweight (bullish), negative values indicate underweight (bearish), used to measure the relative preferences and adjustment directions of institutional investors.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Korean Market (Korea)

  Mixed Benefit/Detriment: Significant foreign inflows this week, but high leveraged ETF levels bring volatility risks

  Strengths

  Net foreign inflow of $1.7 billion this week; although mutual funds reduced holdings, the industrial sector received rotational inflows

  Weaknesses

  Year-to-date net foreign outflow of $76.4 billion; high proportion of leveraged ETFs leads to Gamma rebalancing amplifying volatility

  Comparison

  Compared to Taiwan, Korea has larger leveraged ETF sizes and a higher proportion of foreign capital, resulting in a more significant volatility amplification effect

  Risks

  Mechanical selling pressure caused by market maker Gamma rebalancing, exacerbated intraday volatility

• Taiwanese Market (Taiwan)

  Beneficiary: Significant foreign inflows this week, relatively lower leverage risk

  Strengths

  Net foreign inflow of $3.3 billion this week; low proportion of leveraged ETFs in free-float market cap (<0.6%)

  Weaknesses

  Year-to-date net foreign outflow of $11.5 billion; retail investors had a net outflow of $2.7 billion this week

  Comparison

  Leveraged ETFs are mainly domestically issued; rebalancing flows impact less than 2% of turnover, far lower than in Korea

  Risks

  Selling pressure from retail investors, fluctuations in the global technology cycle

• Chinese Market (China)

  Beneficiary: Significant increase in mutual fund holdings in May

  Strengths

  Mutual fund allocation increased by 100bp in May; capital rotated from industrials to banks

  Weaknesses

  Year-to-date net foreign outflow data is not directly given but implied in total Asia-Pacific outflows; Southbound capital had a net outflow this week

  Comparison

  Compared to Korea and Brazil, China and India were the main directions for institutional position increases in May

  Risks

  Pace of macroeconomic recovery, effectiveness of policy implementation

• Indian Market (India)

  Beneficiary: Mutual funds increased holdings in May

  Strengths

  Mutual fund allocation increased by 45bp in May; domestic institutional investors (DII) bought $48.3 billion year-to-date

  Weaknesses

  Year-to-date net foreign outflow of $29.8 billion

  Comparison

  Like China, it was a key focus for institutional position increases in May, with strong support from domestic capital

  Risks

  High valuations, persistent pressure from foreign capital outflows

Key data

• Net Foreign Inflows in Asia-Pacific Ex-China This Week$5.7 BillionPrimarily driven by Taiwan (+$3.3B) and Korea (+$1.7B)
• Peak AUM of Korean Leveraged ETFs$40-47 BillionAccounting for 1.4%-2.6% of free-float market cap
• AUM of Taiwanese Leveraged ETFs$9-10 BillionAccounting for 0.5%-0.6% of free-float market cap
• Net Inflows to Global Equity Funds This Week$126 Billion$32 billion last week, US funds net inflow $119 billion
• May Mutual Fund Allocation ChangesIncreased China/India, Decreased Korea/BrazilChina increased by 100bp, Korea decreased by 165bp
• Southbound Capital Net Outflow This Week$600 MillionYear-to-date cumulative net inflow $38 billion

Impact & implications

The report believes that although fundamentals are strong, the growing leveraged positions in the Korean and Taiwanese markets have created a structural environment where market volatility is easily mechanically amplified. For investors, this means that while enjoying the benefits of market gains, they need to be wary of the risk of sharp short-term pullbacks. The report suggests using derivative overlay strategies (such as Put Spread Collars) to manage downside risk while maintaining core positions, which is lower cost and more efficient compared to directly purchasing put options. Additionally, the rotation of mutual funds towards China and India indicates that institutional capital is seeking markets with more attractive valuations or higher growth certainty, which may provide support for blue-chip and banking stocks in these related markets.

Risks

• Market maker Gamma rebalancing risks caused by the surge in leveraged ETF sizes in Korea and Taiwan, which may mechanically amplify intraday market volatility and pullback magnitudes.
• Retail investor margin balances hitting historic highs; if the market reverses, it could trigger a chain reaction of deleveraging.
• Mutual fund position adjustments may cause short-term liquidity disturbances, particularly for the Korean and Brazilian markets where holdings were reduced.

What to watch

• Changes in assets under management (AUM) of leveraged ETFs in Korea and Taiwan, and option implied volatility.
• The proportion of market maker Gamma rebalancing flows to average daily volume (ADV), especially on days of significant market volatility.
• The direction of mutual fund allocation adjustments for China, India, Korea, and Brazil in June and subsequent months.
• The continued flow of Southbound capital and its impact on Hong Kong stock technology and financial sectors.