‘Track the real-time NAV’

Leading Indian fund houses are today taking to passive products such as Exchange Traded Funds. We spoke to the people who pioneered ETFs in India to understand how they work in the imperfect Indian market.

Excerpts from an interview with Sanjiv Shah, Co-CEO, Goldman Sachs Asset Management (India):

While ETFs are globally a good vehicle for passive investing, market prices of ETF units in India often move significantly away from the underlying NAV. What causes this and how can the gap be narrowed?

Our advice to investors is to always choose ETFs that have high secondary market liquidity and large corpuses, as these ETFs generally trade within a very small band to their real-time indicative NAV. Also, the beauty of an ETF structure is that if it trades significantly away from NAV, market makers automatically jump in and close out the arbitrage between the price and NAV by redeeming ETF units directly with the Fund.

This inherent mechanism ensures that ETF will trade around NAV most of the time.

The big advantage of ETFs over mutual funds, both globally and in India, is the concept of a Real-time indicative NAV. This is published by the ETF providers on their Web sites and tracked widely by market participants.

Consequently, investors can track the real-time NAV and trade as per the latest price movements. If there is sharp rise or fall in the market, the same will be immediately reflected in the traded price of the ETF.

What are your comments on index construction and changes in India? Are changes to index constituents more frequent than in developed markets? Are ETFs able to replicate changes efficiently?

The index construction industry is India is actually quite mature with various popular indices such as Nifty, Sensex, Bank Nifty, etc.

Also, there are well-developed criteria/processes established by index providers for undertaking index changes. ETF providers consequently have developed established processes to replicate these changes.

What measures can a fund house put in place to improve liquidity in ETFs? Can there be a market-making mechanism?

Most ETFs already have a market-making mechanism in place. However, some products such as Nifty and gold that have significant investor interest attract natural liquidity resulting in narrower spreads. It is important to note that the liquidity of an ETF is actually liquidity of underlying stocks and not merely the number of ETF units traded.

Fund managers often complain that the Indian market lacks depth beyond the top 100-150 stocks. This is especially so in dull market conditions. Does this make it a less conducive market for ETFs?

ETFs track the natural evolution of capital markets, and help in further development.

As currently, there is good liquidity in the top 100-150 stocks, most Indian ETFs are based on these stocks.

Globally, ETFs are also used by institutional investors to gain more liquid access to asset classes where secondary market liquidity is limited.

We believe that India will also follow a similar path of evolution.

The government recently suggested that ETFs structured with the top 100 stocks and PSUs be brought under the ambit of the Rajiv Gandhi Equity Scheme. What is your view?

We believe this is an innovative scheme introduced by the government to attract a large number of new, small investors into the capital markets.

The use of ETFs structured with the top 100 stocks and PSUs, ensures that investors have access to a diversified basket at a low cost.

Given that many PSUs have low float, is an ETF based on PSUs a workable proposition? Will managers of such ETFs face problems of liquidity and impact cost?

We believe that an ETF on PSU stocks would enable investors to get a more liquid mechanism to access high quality PSU stocks. We think the ETF concept will actually help address the challenge of low liquidity in PSU stocks.

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