Ahead of the South Korean government implementing a partial reactivation of short selling from May 3, local retail investors have voiced concerns over possible losses in battles with sophisticated hedge funds.

The resumption, however, is likely to have a limited impact on the local indexes, global investment bank Morgan Stanley said Tuesday.

“We view a sharp market correction as unlikely and expect the Kospi to remain range bound (2,950-3,250),” the report read, adding that the investment bank has raised its assumption from the previous 2,900-3,200 points amid the National Pension Service’s recent decision to lift the domestic equity weighting.

Although the upcoming short selling resumption is set to restrict constituents in the Kospi 200 and Kosdaq 150 indices, Morgan Stanley said that the slightly changed rule should not change the market dynamics too much. It cited that the total volume of short selling accounts for 6 to 6.5 percent in South Korea, which is much lower than in other markets, including the US and Japan at 35-40 percent.

Unlike previous cases of when short selling has resumed, investors’ movement may be varied this time. Previously, foreign investors’ flows picked up while domestic retail investors’ investment gradually slowed after the lifting. But retail participation is higher while foreign inflows look less certain this time.

“Retail short selling is expected to grow slowly, and in view of the various control measures and restrictions, downside risk from retail short selling appears low. In 2019, retail short selling accounted for less than 1 percent of total short sale transactions and it would be a far cry to reach Japan‘s level of 25 percent in the near term.”

Especially with the market valuation reaching near a historical high, a rise in short selling does not necessarily mean that share price underperformance in the mid- and long-term is likely, it said. The investment bank further forecast that market performance would depend more on economic cycles and corporate fundamentals.

With the outlook, Morgan Stanley recommended investors to avoid “richly valued stocks,” such as those in leisure services, software, health care, consumer staples and IT appliances, and to be selective. It suggested sectors such as steel, IT, financial services, telecom and chemicals, adding they were mid- to late-cycle performers.

“Holding companies’ discounts have widened further since March last year, when the short selling ban was implemented. We believe their underperformance reflects the market’s preference for growth stocks and with the wider valuation gap that resulted,” the report read. “So preferring holding firms over major listed subsidiaries should work when the short selling ban is lifted.”

By Jie Ye-eun (yeeun@heraldcorp.com)