So why are these ETFs trading at premiums, how does this affect investors, and what alternatives exist to avoid overpayment? Let's break it down.
Why are international ETFs traded at premium?
The main reason behind price distortion is regulatory restrictions. The Securities and Exchange Commission of India (SEBI) and the Reserve Bank of India (RBI) have imposed strict restrictions on overseas investments by mutual funds. According to these guidelines, Indian mutual funds can invest a total of $7 billion in foreign stocks, while international ETFs have another sub-limit of $1 billion. These caps have not changed for nearly a decade.
These restrictions reached 2022, leading SEBI to direct Asset Management Companies (AMC) to halt new inflows into these ETFs. While existing ETF units continue to trade on stock exchanges, AMCS is no longer able to issue new units to meet new demand. This will continue to increase the profits of investors and create a supply crunch with ETF prices exceeding the NAV.
The impact of premiums on returns
The price of an ETF should ideally match the NAV, which represents the total value of its underlying asset. However, discrepancies in demand supply have resulted in a substantial price premium, affecting investors' returns.
For example, if the NAV in the ETF has a NAV of Rs 100, but is trading at Rs 115, the new investor will need to add an evenly 15% return. This premium effectively reduces potential profits and puts investors at downside risk if the ETF price is correct.
The risk of buying ETFs at premium
Historically, ETF premiums remained within the 5% range, but have been unpleasant due to recent surges in demand. Some ETFs show prices and NAVs converge within a few days, while others can take up to 240 days. In most cases, price convergence occurs within a year. This means that investors who buy premiums can suffer short-term losses.
How to track and avoid ETF premiums
To avoid overpayment, investors should compare the ETF's trading price with Indicative NAV (INAV). This reflects the real-time value of the underlying holding. Fundhouses frequently update INAVs on websites like BSE and stock exchanges.
If the ETF's trading price is consistently above INAV, it is clear that the fund is trading at a premium. In such cases, investors should reconsider the entry point in place of a market order or use a restricted order to avoid overpayment.
Smarter alternatives: Direct investment through LRS
For investors looking to bypass these ETF premiums, there are viable alternatives. Direct foreign investment through a liberalised remittance scheme (LRS). Under the LRS, Indian investors can transfer up to $250,000 a year to invest in the global market.
By investing directly in US listed ETFs or stocks, investors can avoid paying inflated premiums and ensure that the purchase price closely matches the actual value of the asset. This approach not only improves potential returns, but also increases the flexibility of asset selection.
Should I avoid international ETFs?
Despite those drawbacks, international ETFs remain a convenient way to gain exposure to the global market. However, if premiums are high, investors must be cautious.
If you choose to invest through an ETF, consider the following:
- Use limited orders to avoid overpayment.
- Increased SEBI's overseas investment restrictions could reduce future ETF premiums by monitoring regulatory updates.
- Waiting for price adjustments or researching direct investments via LR.
Final Thoughts
The current premiums of international ETFs highlight the key challenges of global investment. Regulatory constraints create artificial supply and demand imbalances. ETFs offer an easy route to diversification, but rising prices reduce returns and increase risk. Investors should carefully evaluate NAV Premium before purchasing and exploring direct investment options via LRS for a more cost-effective approach.
In investment, knowledge is power. Understanding ETF premiums and NAV convergence allows investors to make informed decisions without unnecessary costs and maximize their global investment potential.
(The author of this article is Viram Shah, Founder and CEO of Fiscal Finance.)
