Buying a security using a margin account means you are borrowing money so you can buy more shares than you have cash for. This is risky, because if your investment goes down, you have lost not only your money but the money you borrowed. Let's look at why this won't work for mutual funds, while looking at other ways you can buy other types of funds on margin.
The Difference Between Stocks and Mutual Funds
Because of the pricing/trading mechanisms used with mutual funds, they cannot be bought and sold like stocks. When trading stocks, an investor can place limit orders, engage in short selling, buy on margin, and make trades in the secondary market throughout the day.
Mutual fund shares, on the other hand, are issued to buyers and redeemed from sellers directly by the fund company. Fund share prices are determined once a day after the close of business and are based on the closing prices of the underlying securities in the fund's portfolio. Fund share buy-and-sell prices are not posted until the day after the transactions occur. This makes it difficult to get out of a mutual fund quickly when it is losing money. For this reason, you cannot buy mutual fund shares using a margin account.
Using a Margin Account for ETFs
Because of these limitations with conventional mutual funds, exchange-traded fund, which are index mutual funds structured and listed as stocks, were originally created in response to professional traders' desire to trade funds with the same facility as stocks.
You can buy ETFs on margin. It is important to understand the risks. If you borrow money to buy an ETF and it drops in value, you will have to make a deposit in your margin account. In addition, you will pay interest on the money you borrowed. Either of these situations can be fatal to your investment. And even if you don't lose the entire investment, the costs eat into your profits from your ETF.
Then there is the double threat: Some ETFs use margin to buy the securities they hold. When you see an ETF that attempts to achieve twice or three times the rise from its underlying index, that means the fund is using leverage, or borrowed money, to attempt to achieve those results. Then, if you borrow money to buy that leveraged ETF, you have even more risk. Also, brokers will not let you borrow as much money to buy this type of ETF. The potential losses are enormous. For example, an ETF that seeks twice the performance of an index can lose twice as much when the index drops. If you have borrowed money to buy that fund, you are losing money faster, too. You could lose as much as three or four times the money in a single drop.
How You Can Use Margin to Profit From a Mutual Fund
If you really want to use leverage in a mutual fund, buy a mutual fund that uses leverage itself. The fund can borrow up to 33.33% of its portfolio value to buy more securities. The fund takes on the borrowing expense. Note, however, that you can still lose money fast if the fund has guessed wrong. You won't have to deposit money in a margin account to make up for the loss, but you do end up paying for the loss when the mutual fund net asset value (NAV) goes down as a result of the loss.
The Bottom Line
Investing on margin is a sophisticated, risky maneuver that can burn even experienced investors. If you want to get in on the world of investing on margin, educate yourself. Better yet, work with an advisor who can steer you through the pitfalls. (See also Introduction To Exchange-Traded Funds.)