Buying a security on margin involves purchasing that security by borrowing the money to make a purchase. This doesn't work for all types of securities, with mutual funds being one of those types.
What Is Margin?
A margin account is a brokerage account in which the account holder can use margin to purchase securities. The loan is collateralized by the value of other securities that the account holder already holds in the account. The account holder may experience a margin call if the value of the securities falls be below a certain level. If the account holder doesn't meet the margin call and adds additional capital to the account, they may be sold out of some or all of the securities they used margin to purchase. This could result in a loss if the price has dropped. Margin trading is risky; investors should understand these risks.
Why Mutual Funds Can't Be Purchased on Margin
Unlike ETFs, individual stocks, closed-end mutual funds and other exchange-traded vehicles, mutual funds cannot be bought and sold during the trading day. Mutual funds are only offered directly by the mutual fund company. Investors must have the full price of the fund purchase they wish to make in cash.
Mutual fund trades settle at the end of the trading only. This means that mutual funds are only priced after the end of the trading as well. Mutual funds can't be sold quickly if they are losing money and positions need to be liquidated quickly if the fund is losing money.
While mutual funds cannot be purchased on margin, they can be used as collateral for margin purchases of other securities in some cases. Requirements will vary a bit by brokerage firm, generally the fund must be held for 30 days in order to be marginable.
Purchasing ETFs on Margin
While open-end mutual funds cannot be purchased on margin, ETFs and closed-end mutual funds can often be purchased in a margin account.
ETFs are essentially mutual funds that can be bought and sold like shares of stock throughout the trading day. ETFs are continually priced during the trading day. This is one of the reasons that ETFs were created in the first place. Their pricing and structure allows them to be purchased on margin, like stocks. They can also be sold short and otherwise be traded on the same fashion as individual stocks.
There are a number of ETFs with high trading volumes during the trading day. Most of these are index ETFs that are a proxy for major market benchmarks. One example is the SPDR S&P 500 ETF (SPY) - Get Report . This is one of the most widely traded ETFs and is an index ETF tracking the popular S&P 500 index. Many professional traders use this fund as a proxy for the stock market as a whole, or at least for large cap stocks.
Not all ETFs are created equal, and not all types of ETFs are good candidates for purchase on margin.
Traditional ETFs, those that invest in stocks or bonds on a long-only basis tend to be good candidates for purchase on margin. Often these are index products, and many follow well-known, widely tracked market benchmarks. The underlying holdings are generally liquid as well.
Non-traditional ETFs may not be as suitable for purchase on margin, however. These ETFs might include leveraged ETFs, inverse ETFs and leveraged inverse ETFs. Often these non-traditional ETFs will have more stringent margin requirements than more traditional ETFs.
One of the requirements of buying securities on margin is called maintenance margin. On many stocks and traditional ETFs, the maintenance margin is often 25% of the value of the margin loan. This means that the securities used as collateral for the margin loan must be maintained at 25% of the value of the loan.
For non-traditional ETFs, the maintenance margin requirements will generally be higher. This is due to the added risk of these ETFs.
Inverse ETFs are designed to move in the opposite direction of the index or benchmark they are designed to track. SH-ProShares Short S&P500 (SH) - Get Report is designed to deliver the inverse return of the S&P 500 index on a daily basis. Inverse ETFs are not designed to be a long-term investment, the inverse feature will not track the opposite direction of the index as well over time. This design can make inverse ETFs a very risky proposition when buying on margin, hence the higher maintenance margin requirements.
The same holds true for leveraged inverse ETFs that combine the inverse feature with leverage. This means that the ETF will not only move in the opposite direction of the index on a daily basis, but this movement will be multiplied by a factor of two or three times. There are also leveraged ETFs that are not inverse, but these are still risky in that if the index they are tracking moves downward on a given day, this drop is multiplied by two or three times for the owners of leveraged ETFs. These additional risk factors make leveraged and leveraged inverse ETFs risky to buy on margin and this is the reason for higher maintenance margin requirements.
Closed-End Mutual Funds
As opposed to open end mutual funds where new shares are created when investors choose to buy into the fund (unless the fund is closed to new investors), closed-end mutual funds are offered with a finite number of shares created by the issuer. Unlike open-end mutual funds, closed-end funds are traded on the stock exchange like shares of individual stocks.
As such, closed-end funds can be purchased on margin. Many CEs already incorporate leverage into their design, so buying them on margin may expose an investor to more leverage and risk than they might realize or be comfortable with.
Use as Margin Collateral
As mentioned above, open-end mutual funds can generally be used as margin collateral, or in other words they are marginable. The same holds true for CEs and ETFs. Which securities are marginable will vary by brokerage firm -- your best bet is to understand all of this when opening a margin account with the firm.
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