Every Exchange Traded Fund (ETF) in India has a mutual fund counterpart. From a regulatory point of view, only mutual fund asset management companies can setup ETFs and an ETF is a special type of mutual fund that happens to trade on a stock exchange. This dynamic allows us to compare ETF closing prices (or last prices, pick your poison) with the corresponding mutual fund NAV to gauge the premium or discount that the ETF is trading at the exchange over the fund.
The calculation is fairly straightforward, it is simply CLOSE/NAV-1. A positive number implies that the ETF is trading at a premium. A negative implies a discount.
Imagine a scenario where you buy an ETF when it is trading at a premium, say, 5%. Suppose the index that it is supposed to track is up 5% and you decide to bank it. You open up your trading terminal and Whoa! The price of the ETF has barely moved. This is because the premium has collapsed and has taken your paper profits along with it.
Think 5% is too much of a difference? Think again. Here is a box plot of the premium/discount of various ETFs over the last year:
The red dots on the charts are outliers. The black line in the middle is the average. Ideally, you want the box to be narrow with no red dots.
The differences cannot be explained away by the popularity of the underlying indices. For example, have a look at NIFTYBEES (from Reliance) and NIFTEES (from Edelweiss.) They both track the tremendously popular NIFTY 50 index but only the former has decent volumes and hews closer to NAV.
Also, the premiums/discounts vary widely. EQ30 is a glaring example of how widely off the mark an ETF could trade.
Investors who use ETFs to create asset allocation portfolios should be especially aware of this phenomenon. A rebalance could very well wipe out mark-to-market profits if it doesn’t take this into account. Moreover, this is not something that is typically modeled in backtests.
Here is a chart of the daily premium/discount over the last one year for the ETFs used in our EQUAL-III Theme:
Forewarned is forearmed!
Code and charts are on github.
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