The recent warnings from the National Stock Exchange (NSE) and BSE on international exchange-traded funds (ETFs) deserve investors’ attention. Several overseas ETFs are trading at substantial premiums to their net asset values (NAVs), exposing buyers to losses that have little to do with the performance of the underlying investments.
Consider the Motilal Oswal Nasdaq Q 50 ETF. On Friday, its units closed at ₹246 on the BSE, against a reported NAV of ₹120.05. This means investors buying at the market price were paying more than twice the underlying value of the ETF’s assets.
Such a premium is difficult to justify, regardless of the prospects of the overseas market. Investors are effectively paying a hefty price merely to gain exposure to securities that the ETF already holds.
Why premiums arise
An ETF’s NAV represents the per-unit value of its underlying assets, while its market price is determined by demand and supply on the stock exchange. Under normal circumstances, the two remain reasonably close because market makers can create or redeem ETF units to exploit price differences.
However, this mechanism has been disrupted in several international ETFs. Overseas investment limits available to Indian mutual funds have been exhausted, restricting the creation of fresh units. With supply constrained, increased investor demand can push exchange prices substantially above NAV.
As Samco Securities points out, demand exceeding the available supply of ETF units is one of the main reasons behind such premiums.
But scarcity of ETF units should not be mistaken for an increase in the value of the underlying investments. A Nasdaq-linked ETF trading at a substantial premium does not mean its underlying technology stocks have appreciated by a similar extent.
The distinction matters because investors face two separate risks. One arises from movements in the overseas securities. The other stems from the possibility that the premium itself will disappear.
An investor can therefore lose money even when the underlying overseas market remains unchanged. Indeed, the ETF’s NAV could rise while its exchange price falls if the premium contracts sufficiently.
The exchanges have specifically warned that an increase in overseas investment limits could restore the creation of fresh ETF units, potentially narrowing these premiums. NSE has also highlighted the implications of SEBI’s revised price-band mechanism, scheduled to take effect from April 1, 2027.
Arbitrage opportunity?
At first glance, a substantial difference between an ETF’s NAV and its market price appears to offer an attractive arbitrage opportunity. Why not purchase units at NAV from the fund house and sell them at the higher exchange price?
The difficulty is that ordinary retail investors generally cannot create ETF units directly with the asset management company in small quantities at NAV. The creation and redemption mechanism operates largely through authorised participants and market makers, subject to prescribed unit sizes and other conditions.
In international ETFs where fresh unit creation is restricted, even these participants may be unable to undertake the usual arbitrage activities that would otherwise narrow the premium.
SEBI does provide a limited safeguard for investors when ETFs become illiquid. Under specified conditions, investors other than market makers can approach the asset management company for direct redemption.
These conditions include the ETF trading at a discount of more than 1 per cent to its day-end NAV for seven consecutive trading days, the absence of exchange quotes for three consecutive trading days, or insufficient bid quantities over a prescribed period.
However, this facility is intended to address liquidity problems. It does not offer investors a way to buy ETF units at NAV and immediately sell them on the exchange at a premium. Nor does it protect those who have already paid an inflated market price.
Price matters
Premiums and discounts are not confined to international ETFs. Gold ETFs, as well as ETFs tracking the Sensex, Nifty and other indices, can also trade away from their NAVs. However, such deviations are generally easier to correct where the underlying securities are accessible and the creation-redemption mechanism functions normally.
Investors should therefore examine more than the index an ETF tracks or its recent market-price performance. The premium or discount to NAV, trading liquidity, bid-ask spread and ability to create fresh units are equally relevant.
A rising ETF price is not necessarily evidence of a rising underlying market. Part of that increase may simply reflect investors bidding up a limited supply of units.
ETFs can be useful instruments for long-term investing, but their low-cost structure and exchange-traded convenience do not make them attractive at any price.
The basic principle is straightforward: investors should not pay ₹2 for assets worth ₹1 merely because those assets offer exposure to an overseas market. Waiting for a reasonable entry price, or considering an alternative investment route, is preferable to buying an ETF at an unjustifiable premium.