People invest intending to grow their investment in the long term. Sometimes these traders find themselves in a position to leverage their funds to invest. They can leverage these funds from many sources. However, some investors or traders borrow from their brokers. This kind of leverage is known as buying margin.
If we talk about ETFs, Exchange Traded Funds; many traders favor investing in ETFs as they get to invest in a diverse portfolio that includes securities with different levels of risk. We all know that ETFs are traded like any other security on an exchange in the daytime. However, unlike trading a single type of security, it is a portfolio of many.
If you are planning to buy ETFs on margin, this article will highlight important information that you must know before making a decision. The questions that will be answered in this article are— what is an ETF? Is buying ETFs on the margin a wise decision? What are the possible drawbacks or benefits of buying ETFs on margin?
What Are ETFs?
ETFs or Exchange Traded Funds are a group of combined funds invested in a portfolio of securities traded on a stock exchange. These portfolios include a variety of securities like stocks, bonds, commodities, and currencies. Like other securities on a stock exchange, ETFs are also traded only during market hours. The portfolio is focused on a particular type of bond or securities or an index.
ETFs are suitable for those who wish to have diversification in their investment. Diversification helps investors to take risks and, at the same time, keep their assets safe. Since it is a portfolio of different securities, every security comes with varying risks involved. Therefore, some securities in your portfolio will have higher risks, while some will work as a safeguard to prevent your investment from becoming negative.
What Is Buying on Margin and Margin Accounts?
Buying on margin refers to borrowing funds from the brokerage to buy securities. It is a common practice amongst traders and investors. When people are a little short on funds, they buy on margin with the help of their broker. Your broker will lend you money through a brokerage account or a margin account that can be used to make the partial payment of your investment.
It is essential to know that margin accounts do not provide leverage for your entire investment. They only offer partial funds, which is typically 50%. The other 50% is paid through your bank account. Your account should have the minimum funds, about a thousand dollars, to be eligible to buy on margin.
The funds leveraged through a margin account are loans that require you to pay interest until you have successfully repaid the borrowed funds. The interest and the repayments must be made timely, irrespective of the performance of your ETF or other investments in the market.
Can you buy an ETF on margin?
ETFs can be bought both in cash and on margin. However, it is not wise to purchase ETF on the margin because the risk is involved with leveraging ETFs. The leveraged funds need to be repaid along with interest. The repayment is irrespective of how your ETFs are performing in the market. Even if your investment in ETFs decreases, you will still have to repay.
Borrowing through margin accounts requires you to maintain a cash balance of 25% of leveraged funds in your reports. If the value of your ETFs declines, the brokerage will provide you with a deadline to raise the balance in your accounts. You would either have to add more cash or sell other securities to collect funds. If you cannot add funds by the deadline, the brokerage will make up for their loss by selling your ETFs.
Another disadvantage of buying on margin is the interest payment. If the returns on your investment are not enough, you may pay a large portion of the profits, or maybe the entire profit, towards interest. If your ETFs cannot generate enough profit on which you can pay the interest and still be left with some profit, then buying ETFs on margin will be a wrong decision.
There are different types of ETFs, and one of them is the Leveraged ETF. These ETFs have a higher risk as compared to standard ETFs. To gain higher profits, leveraged ETFs use margin within the funds, which increases the risk. The higher risk is due to the double margin because the leveraged ETFs you are buying on margin is already using margin with the funds. Therefore, the brokers set a limit on the use of margin accounts, as the losses on Leveraged ETFs can be very high.
Can Buying ETFs on Margin Be Beneficial?
It is not always true that buying ETFs on margin is wrong. If the investor does thorough research about the ETFs he is planning to invest in, he can still make a profit, even after buying on margin. There are cases where investors are in profit, even after paying the interest on the margin account borrowings. Let us understand this with the help of an example.
You invest $4,000 in ETFs. If your investment gives a return of 10%, then your net gain will be $400. If you invest double in the same ETF, $4,000 is paid by you in cash and $4,000 via your margin account. Your total gain on this investment would be $800. The interest to be paid on the borrowed funds from the margin account is 5%, which is $200. Your net gain will be $600, which is still $200 more than what you were earning before borrowing.
In the above case, the investor earned more profit with the help of margin buying than what he was making without borrowing. Buying ETFs on margin can be beneficial only if the expected returns are higher. The risk is higher when buying on margin. However, the profit can also be higher.
You can utilize this profit to earn more or save your profit. Using this profit to generate more returns would be a wiser decision. As you will still have to pay interest on your borrowed funds, you can use them at the time of downfall in the market. You can even invest this profit in other securities to generate more returns.
It is impractical to buy ETFs on margin if they generate profits that are less than the interest you have to pay. Not just the ETFs, you may also end up losing your other funds or assets. In the case of leveraged funds also, it is advisable not to buy them on margin. They may show possibilities of higher gains, knowing that it is just a possibility and not a prominent event. With higher gains comes higher risks.
Expand Your Knowledge About Buying on Margin and ETFs
You can achieve better results while investing in ETFs and buying on margin if you know how they function and how they can work best for you. The following are some sources that investors can use to learn about ETFs and buy-on margins.
Educational Books- There are several books written on ETFs and Buying on Margin that will help you become a better investor. The best amongst these are ‘Margin Trading from A to Z’ and ‘ETF Investing 101’. Both the books contain immense knowledge about their respective topics. Even a beginner would be able to learn so much from them. Both the books are available on Amazon.com.
YouTube Videos- If you are a beginner and want to learn basic knowledge about ETFs, their risks and benefits, and their trading techniques, you can check the video via Ameritrade. For buying on margin, the video by Fidelity Investment is very informative.
There is a certain level of risk involved in investing in ETFs. Even if they include securities with diversified risk levels, the market is an unpredictable place where even the best can perform the worst sometimes, or the worst becomes the star of the market. Buying on margin itself is very risky. Therefore, you must be sure about the positive outcomes of your investment before buying ETFs on margin.
Buying on margin involves repayment of the borrowed funds along with interest. If your investment is not efficient enough to generate funds for the repayment, it is worthless to buy on margin. Not to forget that failing the repayment can affect your other investments; you will certainly not want that. Thorough research is a must to ensure that the net gains from your investment exceed the repayment, including the interest.