What Are ETFs?

An exchange traded fund (ETF) is a type of security that tracks a specific asset, index, or sector. First developed in the 1990s, they provide investors with a way to access passive, indexed funds. The market has grown tremendously since the first ETF hit the market. In fact, more than 160 different companies offer ETFs to investors. But what exactly are they?

ETFs are just like stocks. Investors can purchase shares of ETFs on national exchanges the same way they would with stocks. Their prices are quoted and updated throughout the day. And just like stocks, ETFs can also be purchased on margin. By trading ETFs this way, investors have the potential to magnify their returns. But this also means there's the potential for losses, too. So how does this all work? In this article, we will discuss the rules and risks of buying ETFs on margin.

Key Takeaways

  • Exchange traded funds are securities that trade like stocks and track assets, indexes, or sectors.
  • Investors can trade ETFs on margin just like stocks.
  • FINRA rules set a 25% maintenance margin requirement for most securities, including ETFs.
  • The maintenance requirement for leveraged long ETFs is 25% multiplied by the amount of leverage used as long as it doesn't exceed 100%.
  • The maintenance requirement for a leveraged short ETF is 30% multiplied by the amount of leverage used, not to exceed 100%.

Traditional ETFs

An ETF can be actively or passively managed. A passively managed ETF aims to mirror the performance of a chosen benchmark such as the S&P 500 Index or Dow Jones Industrial Average (DJIA). An index ETF is a cost-efficient way for investors to gain exposure to a broad basket of stocks and generate returns that are similar to the market's overall performance.

Under rules set by the Financial Industry Regulatory Authority (FINRA), traditional ETFs have the same maintenance margin requirements as equities. A broker can lend up to 50% of the purchase of margined securities for initial purchases. After that, the equity in the borrower's account cannot dip below 25%.

Investors whose account balances fall below 25% may face a margin call. If this happens, they need to deposit additional funds or sell some of the assets in their account to bring the value back above the 25% threshold.

Leveraged ETFs

Non-traditional ETFs such as leveraged ETFs are subject to more stringent maintenance margin requirements. A leveraged ETF aims to generate daily returns that are 2x or 3x the underlying index it tracks.

These funds make use of derivatives (mainly futures and swaps) to be able to meet their daily target. For example, the ProShares UltraPro QQQ ETF seeks daily returns that are three times the daily performance of the Nasdaq 100 Index.

According to a 2009 FINRA regulatory notice, the maintenance requirement for leveraged ETFs is 25% multiplied by the amount of leverage used, not to exceed 100% of the value of the ETF. For example, the maintenance requirement for a 2x leveraged long ETF would be 50%, or 2 x 25%. For a 3x leveraged long ETF, the maintenance requirement would be 75%, or 3 x 25%.

Inverse ETFs and Leveraged Inverse ETFs

As the name suggests, inverse ETFs are designed to deliver daily returns contrary to the movement of an underlying index. When the underlying index falls, these ETFs rise. Inverse ETFs are useful tools in bear markets. An example would be the Direxion Daily S&P 500 Bear 3x Shares ETF, which aims to move 300% opposite the performance of the S&P 500 Index.

Leveraged inverse ETFs work the same way as inverse ETFs but use derivatives to meet their daily target. The maintenance requirement for inverse leveraged ETFs is 30% multiplied by the amount of leverage used, not to exceed 100% of the value of the ETF. For example, the maintenance requirement for a 1x inverse ETF would be 30%, or 1 x 30%. For a 3x leveraged inverse ETF, the requirement would be 90%, or 3 x 30%.

The Bottom Line

Buying a leveraged ETF on margin is risky, because you are using leverage on top of leverage in an attempt to profit from the short-term movement of an underlying index. It's important to remember that leveraged ETFs and inverse ETFs aim to replicate the daily (as opposed to annual) performance of the index they track. Due to the high-risk, high-cost structure of these ETFs, they are rarely used as long-term investments.

As such, non-traditional ETFs need constant monitoring. Holding them for multiple trading sessions can erode your gains significantly. Buying non-traditional ETFs on margin simply amplifies these risks and therefore should be avoided, especially by novice traders.

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 committing your investment dollars, especially when using capital obtained on margin.