Buying on margin is like shopping with a credit card, as it allows you to spend more than you have in your wallet. Buying on margin is an old technique practiced not only by seasoned investors and traders, but even rookies. The prospect of being able to buy securities using more money than one has entices many investors to try out new products. But remember, the riskier the financial instrument, the higher the stakes when you opt for margin buying. Let’s look at how exchange-traded funds (ETFs) can be bought on margin and where to watch out! (See our tutorial, "Margin Trading.")
Typically, ETFs aim to mirror the performance of a chosen index or benchmark (say S&P 500, Dow Jones, etc.). ETFs are perceived to be a less-risky and cost-efficient way to invest in stock markets. But some variations of ETFs (known as non-traditional ETFs) are more complex and risky than traditional ETFs. Although non-traditional ETFs are listed and traded like regular ETFs, few distinct features separate the former from the latter.
Traditional ETFs
The objective of these ETFs is not to beat the market index, but match it. These ETFs try to replicate the movement of an index or benchmark on a 1:1 basis. Such ETFs are classified as traditional funds by FINRA and have the same margin requirements as regular stock holdings. In such cases, the initial margin requirement is 50% of the purchase price, while 25% is required as maintenance margin.
Non-Traditional ETFs
- Leveraged ETFs
Leveraged ETFs work to multiply an index's daily moves by two to three times, thereby magnifying the index's returns, risk and volatility. These funds make use of derivatives (mainly futures and swaps) to be able to meet their daily target. The maintenance requirement by FINRA for leveraged ETFs is 25% multiplied by the amount of leverage (not to exceed 100% of the value of the ETF). So, the maintenance requirement for an ETF leveraged on a 2:1 ratio will be 50% (25% x 2), and for a 3:1-leveraged ETF, it would be 75% (25% x 3). In the case of day trade, the day-trade buying power for an account will be reduced by one-half and one-third, respectively, for 2:1- and 3:1-leveraged ETFs.
- Inverse ETFs
As the name suggests, inverse ETFs are designed to deliver the opposite of the underlying index movement. When the targeted index goes down, these ETFs move up and hence are a technique to survive in bear markets. Use of words such as "bear," "inverse" or "short" is found in such funds. The maintenance margin requirement is 30% in such funds. The investor will receive a margin call for additional funds if his equity in these funds falls below that mark.
- Leveraged Inverse ETFs
These blend "leveraged" and "inverse" ETFs and magnify the index movement by two or three times but in the opposite direction. So, if the underlying target index moves down by 1.5%, a 2:1-leveraged inverse ETF should move up by 3%. In such cases, the maintenance margin requirement is 30% multiplied by the leverage level. Thus 2:1- and 3:1-leveraged inverse ETFs will have a maintenance margin requirement of 60% and 90%, respectively.
Indulging in Buying on Margin?
- Buying traditional ETFs on margin is a reasonable bet. But when it comes to non-traditional ETFs, their functioning must be very clear to be able to make profits.
- Non-traditional ETFs do manage to meet their daily target (2:1 or 3:1), but since they "rebalance" daily, the long-term results may be skewed. Say you have bought a 3:1-leveraged ETF that targets thrice the return of index XY. You pay $100 to buy a share of ETF when the benchmark index is at 10,000. If index XY zooms up 10% the next day to 11,000, the leveraged ETF would increase 30% to $130. Now, if the index falls from 11,000 back down to 10,000 the following day, there is a 9.09% decline. The leveraged ETF you are holding would go down thrice, i.e. by 27.27%. Now, although the index returned to the starting point, a 27.27% decline from $130 would leave you with an ETF share worth just $94.55, i.e. the ETF share is down by 5.45%.
- Non-traditional ETFs need constant monitoring and should be bought strictly for short term, as indulging in multiple trading sessions can erode your gains significantly.
- Investors ignoring these considerations either fail to exit at the right time or end up buying at the wrong time, resulting in losses.
- Buying non-traditional ETFs on margin should be avoided, especially by rookies, as margin trading involves interest charges and risks!
Click here to read the complete FINRA regulatory notice on non-traditional ETFs.
The Bottom Line
The strategy of buying ETFs on margin should be avoided by novices. For those who have experience with buying on margin, it can work to amplify returns, but they should be extremely careful while dealing with non-traditional ETFs. These ETFs should be monitored very closely, as their long-term performance can significantly differ from their "daily" targets. Remember, margin buying incurs interest charges, and thus can dent your profits or add to losses. Be sure to understand the investment objectives, charges, expenses and risk profile of an ETF before indulging in it, especially on margin!
Further Reading: For information on buying country ETFs, see "The Top 10 Factors when Buying Country ETFs.")
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