The landscape of international investing through exchange-traded funds (ETFs) in India has become increasingly complex, with investors facing unprecedented challenges in entering global markets. Regulatory restrictions and market dynamics have created a unique investment environment in which foreign ETFs trade at significant premiums.
The stranglehold of regulations
The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) have implemented guidelines that impact international investment opportunities. Mutual funds are only allowed to invest $7 billion in foreign stocks and $1 billion in international ETFs. These restrictions, which have remained virtually unchanged for almost a decade, have limited the global investment channel.
The premium paradox
The most alarming aspect is the unprecedented premium at which these ETFs are trading. These funds trade at premiums ranging from 15% to 20% above their net asset value (NAV).
The question is how to know if the ETFs are trading at a premium. One way is to compare their indicative NAVs (iNAVs) with their market trading prices. The NAVs for ETFs are published daily on the Association of Mutual Funds in India (Amfi) website, while the iNAVs are updated regularly during market hours. This can be found on the specific ETF pages on stock exchange websites.
For example, to check whether an ETF like the Motilal Oswal NASDAQ 100 or the Mirae Asset Bank Plus ETF is trading at a premium, compare the iNAV from the exchange’s website to the price at which it is trading in the market. The difference between the trading price and the iNAV indicates whether the ETF is trading at a premium (if the trading price is higher) or at a discount (if the trading price is lower).
Typically, ETFs are designed to closely track their underlying assets through an arbitrage mechanism. Professional market makers and authorized participants normally create or purchase ETF units to keep the price aligned with the underlying securities.
However, the current market situation has disrupted this delicate balance. The regulatory restrictions have effectively frozen the creation of new ETF units, creating artificial scarcity. This scarcity creates an imbalance between supply and demand, making existing units disproportionately expensive. And this premium affects the potential return.
But why are investors increasingly turning to foreign ETFs?
The market rise after the elections
The recent US election results have generated significant interest in international markets through several compelling avenues. Technology innovation is at the forefront, with the Nasdaq 100 representing a concentration of cutting-edge technology companies offering exposure to leaders in artificial intelligence (AI), cloud computing and overall digital transformation. Investors are increasingly recognizing the potential of technology indices.
Moreover, the desire for global diversification has become paramount as investors look for opportunities outside domestic markets to mitigate local economic risks.
Distributors are reporting huge demand for international funds, with investors showing a particular preference for the Nasdaq 100 ETF due to its broad exposure to US markets. However, this enthusiasm comes with a critical caveat: the inflated price mechanism currently at play.
The liberalized cash transfer scheme: a strategic alternative
The LRS offers a strategic alternative for smart investors. Although there is a 20% withholding tax, this approach offers nuanced options that deserve careful consideration. The TCS is not a final tax but a collection mechanism that can be claimed as credit while filing income tax returns, potentially offering significant benefits.
Investors can effectively offset this against their overall tax liability, which can ultimately make it more cost-effective than paying the high ETF premiums. The LRS provides direct access to international markets, allowing investments of up to $250,000 per year with greater flexibility than domestic ETFs.
Investors holding ETFs with a premium of more than 15% should reconsider their position. The most prudent approach would be to compare the total cost of LRS investments with that of premium ETFs, possibly taking advantage of the tax credit system.
A word of warning
This whole analysis is not about creating fear or panic. It’s about understanding the nuanced landscape of international investment. Many investors jump in blindly, attracted by the glamor of international markets. True investment success comes from understanding, not following. When an ETF’s market price eventually converges with its NAV, returns will normalize, catching many off guard.
The international investment landscape is not static. The regulatory environment will evolve, market sentiment will change and new opportunities will emerge. The most successful investors are those who stay informed, remain flexible and approach investments with a strategic, analytical mindset.
After all, in the investment world, knowledge is not just power, but also protection.
Arihant Bardia is the founder and CIO of Valtrust Capital.
