Indian investors are overpaying for foreign ETFs. Beware the risks.u

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From 4 to 9 September, the Nasdaq Q-50 index — made up of 50 companies next in line to enter the Nasdaq-100 — did little. However, an Indian exchange-traded fund (ETF) based on this index — Motilal Oswal Nasdaq Q50 — saw its market price shoot up by 50%. On 9 September, each unit of the fund was bought and sold for ₹ 213, while the NAV, or intrinsic value, was just ₹ 117. That is an 81% premium.

This is a rare phenomenon, but nothing new. In fact, this is the reason I have spent my working life studying mutual funds. In 1992, my father sold 5,000 units of SBI Magnum Multiplier, a closed-end equity fund. The NAV was ₹ 20, but the market price was ₹ 100. Instead of the ₹ 1 lakh that he should have got, he received ₹ 5 lakh, a big bonanza for a middle-class family in those days.

Since he bought and sold these units on the advice of a 22-year-old me, the windfall gave me an unearned reputation as the family's financial genius. My actual bonanza came in the years that followed because this strange experience set me on a lifelong path of understanding mutual funds and explaining them to others.

A word of explanation here. When you buy a normal fund, you buy it from the fund house and pay the NAV. But you buy an ETF from another investor on the stock exchange, like a share, at whatever price the buyer and seller agree on. ETFs have an NAV, which is the intrinsic value of the units, but no one has an obligation to sell you a unit at that.

Usually, the NAV and the market price stay close because of a mechanism in place. If demand is too high and the price drifts up, a dealer pays the AMC, gets new units created, and sells them on the exchange. This pushes the price and the NAV closer. The reverse happens when there's too much selling, and the price drifts down.

So far so good. However, because Indian mutual funds have run into the ceiling for foreign investments, no new units can be created for ETFs that invest abroad. This means the mechanism for keeping the price rational cannot work. Note that in my ancient story about Magnum Multiplier above, no new units could be created because it was a closed-end fund, not because it was an ETF. However, the effect was the same.

So why is all this happening now? Every ETF has a daily price band, a range beyond which the price cannot trade that day. Until 4 September, the band was 20% either side of the two-day-old NAV, so however strong the demand, the price could not close much above what the fund was worth. From 7 September, under Sebi's new rule, the band is drawn around the previous day's closing price instead, and can stretch up to 20% above it. Therefore, for a fund that cannot issue new units, the limit now effectively refers to the previous day's premium.

I won't go into the technicalities or the logic of the rule change — that's a separate topic. However, this has enabled a runaway price.

The important thing investors should understand is that all this is just punting; there is no intrinsic reason to pay this premium.