Hedge funds are up in arms over South Korea’s decision to extend its ban on short selling for six months, even after the country’s stock market made a strong recovery from the March low sparked by the pandemic.

Seoul’s financial watchdog said on Thursday it would extend its initial six-month ban on the short selling of listed stocks until March 15 2021, citing “widening market volatility amid a resurgence of Covid-19”.

The Financial Services Commission said it would also strengthen punishment for illegal short-selling practices.

But hedge fund managers are annoyed at being stripped of an important hedging tool amid fears of a bubble in parts of the stock market inflated by frenzied buying by retail investors. South Korea is one of three countries in the world that maintains such a ban, along with Malaysia and Indonesia.

“There is no reason to extend the ban, given that stock prices have recovered more than enough,” said Albert Yong, head of Seoul-based Petra Capital Management. “The move could inflate a bubble in the bio sector, which could cause bigger losses on retail investors later.”

The benchmark Kospi Composite index has surged more than 60 per cent from its low in mid-March, when the ban was first introduced in the wake of record foreign investment outflows from the export-driven economy.

Retail investors have since bought a net Won22.9tn ($19.3bn) of Kospi stocks as foreign investors and local institutions have retreated.

South Korea’s economy suffered its worst recession in two decades in the second quarter, despite a relatively light lockdown. The OECD expects output to shrink just 0.8 per cent this year, the best result among 37 OECD member countries. Progress on containing the pandemic is uneven, though: the country recently tightened restrictions as cases reached a five-month high.

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The ban on short selling has contributed to a dizzying surge in healthcare stocks, reflecting hopes among some investors that such companies are at the forefront of the race to develop Covid-19 treatments. The Kospi 200 Healthcare index has more than doubled from its trough in March.

“The extension [of the ban] is against the global standards. It is a political move to please retail investors, ignoring some positive effects of short selling,” said Bruce Lee, a former hedge fund manager. “It will undermine capital market efficiency when the market is actually overshooting its fundamentals.”

Some investors said the lengthy ban on shorting would boost retail investors’ sentiment and spur additional inflows into the market, but would discourage hedge funds with long-short strategies from making big bets in South Korea. “The restrictions will certainly make foreign investors like us doubt the maturity of the country’s capital market,” said one US hedge fund manager.

Investors said the inability to short had also hobbled participation in the market for more traditional portfolios, which were unable to hedge exposures to South Korean stocks.

“Clients have definitely walked away from Korea because of the lack of any ability to hedge a long portfolio — not because they want to walk in and short everything,” said one industry veteran.

The Pan Asia Securities Lending Association also queried the commission’s decision to extend the ban. The Hong Kong-based industry group said in a statement that short selling “is an important characteristic of developed equity markets” that helps “manage risk in investors’ portfolios and encourage good corporate governance”.

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Via Financial Times