Can You Buy Mutual Funds on Margin?
Learn if mutual funds can be bought on margin and gain essential insights into the mechanics and risks of leveraged investing.
A mutual fund is a professionally managed investment that pools money from many investors to purchase a diversified portfolio of securities, such as stocks, bonds, or money market instruments. Conversely, margin involves borrowing money from a brokerage firm to purchase securities, effectively increasing an investor’s purchasing power.
Understanding Margin Trading
Margin trading involves establishing a margin account where the firm lends funds to the investor for security purchases. This borrowed money, combined with the investor’s own capital, forms the total available for trading. The securities purchased then serve as collateral for this loan, which accrues interest over time.
The initial margin refers to the percentage of the purchase price an investor must pay with their own money. Under Regulation T, brokers can lend up to 50% of the total purchase price for new purchases of marginable equity securities. This means an investor must deposit at least 50% of the security’s value themselves.
Beyond the initial requirement, investors must maintain a certain level of equity in their account, known as maintenance margin. FINRA Rule 4210 generally sets this minimum at 25% of the current market value of all margin securities. If the equity in the account falls below this maintenance level, a margin call is triggered, demanding additional funds or securities to restore the account to compliance.
A margin loan provides leverage, allowing investors to control a larger position than their cash balance alone would permit. The purpose of margin trading is to amplify potential returns by increasing buying power. However, this amplification also extends to potential losses, making margin a tool that carries elevated risks.
Mutual Funds and Margin Eligibility
Mutual funds are not marginable for initial purchases due to regulatory restrictions and structural characteristics. Regulation T governs the credit extended by brokers for security purchases and generally does not classify open-end mutual funds as eligible for initial margin. This regulation outlines which securities can be bought on margin, and mutual funds do not meet the criteria for such transactions.
The structural nature of mutual funds also contributes to their ineligibility for margin. Mutual funds calculate their net asset value (NAV) only once per day, at the close of the trading day. This lack of intra-day pricing means they do not have real-time market valuations, which is a requirement for collateral in a dynamic margin environment where rapid valuation changes can occur. In contrast, stocks and exchange-traded funds (ETFs) trade throughout the day, providing continuous pricing.
Furthermore, the redemption process for mutual funds can take several business days to settle, typically one to three business days for payment. This delay in settlement makes them unsuitable as collateral for margin loans, especially when a broker might need to liquidate assets quickly to meet a margin call.
Important Considerations for Margin Use
Using margin, when permitted for other securities, amplifies both potential gains and losses. A small percentage change in the value of a leveraged investment can result in a significantly larger percentage gain or loss on the investor’s capital. This leverage means that an investor could lose more money than initially deposited in the margin account.
A margin call represents a demand from the brokerage firm for the investor to deposit additional cash or securities into their account. This occurs when the equity in the margin account falls below the maintenance margin requirement. If an investor fails to meet a margin call within the specified timeframe, the brokerage firm has the right to sell securities in the account without prior notification. This forced liquidation can happen at unfavorable market prices, potentially crystallizing losses for the investor.
Margin loans also incur interest expenses, which are calculated daily and charged monthly. These interest charges add to the overall cost of the investment and can erode returns, particularly if the investment’s performance is weak.
Investors considering margin trading must understand their brokerage firm’s policies, which can be more stringent than regulatory minimums. The margin agreement outlines the terms and conditions, including how interest is calculated and the firm’s rights regarding collateral. It is crucial to monitor account equity closely and maintain sufficient liquidity to avoid the severe consequences of a margin call.