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

The important thing investors should understand is that all this is just punting; there is no intrinsic reason to pay this premium. Photo: BloombergSummaryForeign investment limits and a new Sebi price-band rule have sent international ETF market prices soaring above their intrinsic NAVs, leaving buyers exposed if artificial premiums collapse.Gift this articleCheck your portfolioThis is a Mint Premium article gifted to you.Subscribe to enjoy similar stories.

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. The buyer is buying because the price is rising and he's hoping that a greater fool turns up tomorrow.

The potential returns on the ₹213 you may pay have two parts. There's the real ₹117 part, which will return based on how those 50 American companies do. And there's the ₹96 part where the returns will be based on what the greater fool pays tomorrow. The underlying index could gain 40% over the next two years, and the holding will still lose money if the premium goes back to what it was a few days ago.

I remember that 34 years ago, my father's ₹5 lakh felt like real skill to me, at least for a while. It was tempting to believe that I really was a financial genius, as my family thought. However, I soon understood what investing was really like, and that understanding has been far more valuable than any fake feeling of being a miracle investor. This is a similar moment.

Dhirendra Kumar is the founder and chief executive of Value Research, India&#x27;s oldest independent investment research organisation. Founded in 1992, Value Research has no affiliation with any fund house, distributor, or financial product manufacturer. This structural independence has defined Kumar&#x27;s approach to investing and financial journalism for over three decades.<br><br>Kumar has written about personal finance for Indian households across leading publications for more than three decades, including for Hindustan Times and, now, Mint. His writing addresses a single enduring question: how should an ordinary Indian investor make sound decisions about their money, without being misled, overwhelmed, or sold to? The answer, as his columns consistently demonstrate, lies not in market prediction or product promotion, but in evidence, discipline, and time.<br><br>As the architect of Value Research&#x27;s ratings, among the most referenced in the Indian advisory ecosystem, Kumar brings three decades of proprietary research and fund performance data to every piece he writes. Value Research&#x27;s ratings and editorial opinions are not influenced by its advertising relationships. No fund house can buy a better rating or a favourable column. He serves on the advisory committees of SEBI, PFRDA, and IEPFA.

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