Delhi-based professional Veena Venugopal couldn’t believe her luck when she realized that she was running a profit of 118% in just a single scrip on the stock markets. On 31 October, when she saw her portfolio, she realized that her investment in S&P CNX Nifty UTI National Depository Receipt, more popularly known as UTI Sunder, was up by that margin since when she made that investment on 15 November 2010 even when the Nifty index (UTI Sunder’s benchmark index) was down 17.15% in the past year. She booked profits on the next day (an income of 67,083.96 as against an investment of 29,683.5 in just under a year; a return of 126%) and is now laughing her way to the bank.

Yogesh Kumar/Mint

Differential pricing...

UTI Sunder is an exchange-traded fund (ETF) that is available on the National Stock Exchange (NSE). Like any other ETF, UTI Sunder has a net asset value (NAV)—the value of its underlying asset—and a market price at which its units are traded. The mechanism of the ETF is such that it provides an arbitrage opportunity to a trader or the authorized participant to make money if either the ETF’s market price or its net asset value (NAV) moves up or down.

For instance, as on 8 November, UTI Sunder’s NAV was 577.5011 and its market price reached an intra-day high of 2,024. In this case, the authorised participant would sell UTI Sunder units in the market since it is quoting at a higher price (approximately 2,024) and then replenish his stock by buying the ETF units from UTI Asset Management Co. Ltd at around the prevailing market (and by that measure, the NAV) levels. The market maker’s selling in the market will create a downward pressure on the market price of the ETF units and he will continue to indulge in this arbitrage till the time the market price of the ETF units doesn’t converge with the actual NAV. Some difference will remain, however, on account of transaction costs.

ETFs are passively-managed schemes that invest their entire corpus in a basket of securities, such as equity shares. They are not meant to outperform their benchmark indices; they are supposed to track it passively. Since fund managers are not involved in managing these funds—they work on an automated mechanism instead—these funds are meant for those who like to avoid the fund manager’s risk. However, unlike index funds (also passively-managed) that work like any other MF scheme and buy and sell securities from the stock exchange, ETFs have a different mechanism.

The fund house appoints market makers, who buy the basket of securities (such as all the scrips of the market index on which, say, an equity-oriented ETF is based upon) and hand it over to the fund house in exchange for a certain number of units. This process is called unit creation, whereby ETF units are “created" in exchange for a basket of securities. The market maker then breaks up these units and sells them separately on the stock exchange. Investors can then buy and sell these units from the stock exchange. Normally, authorised participants have enough cash to do it, but even regular investors can create units.

For instance, as per the offer document of UTI Sunder, you need to create a minimum lot of 10,000 Sunder shares (or units) at any point in time. As on 9 November, the total cost of this basket comes to about 52.21 lakh (10,000 units multiplied by 522 or 1/10th of Nifty’s value on 9 November). This basket will contain all the 50 Nifty shares in exactly the same proportion as they lie in Nifty, plus a small amount of cash, as mentioned in the scheme’s offer document. When the market maker wants to redeem these units with the fund house, it does not get cash in return, but the basket of securities.

...can hit you

Ideally, the difference between the market prices and the NAVs of ETFs isn’t supposed to be more than 2%; internationally, it is between 0.1% and 0.5%. Indian ETFs have also typically maintained a difference of about 1% historically, though occasionally these differences have gone up to about 14-16%. Says Paul Justice, director of ETF Research North America, Morningstar Inc, a global MF tracker: “The more liquid the ETF (larger asset base and higher trading volume), the lower the premium/discount typically would be."

Some market experts feel that there could have been some price manipulation by some market participants. Says Arun Kejriwal, director and founder, Kejriwal Research and Investment Services Pvt. Ltd: “This appears to be a case of fraud. We must question as to why Sunder is the only ETF where such an extraordinary deviation in NAV and market price exists. The fund house (UTI AMC) is best placed to explain the current scenario."

A senior official at UTI AMC said: “We have no idea why there has been such a huge surge in the market price and large difference between the market price and NAV." That the fund size is only 64 lakh is also one of the reasons why market sources say the fund house seems to be least interested in this issue. A low corpus is also one of the reasons why UTI Sunder has seen a low volume of its units being traded daily. In the past year, only 130 units on an average were traded on the stock exchange and on some days only one unit was traded. However, the fund saw a slight surge in activity on the markets between 20 October and 8 November.

Says Vinod Sharma, head (private broking and wealth management), HDFC Securities Ltd: “For the price to sustain, you need buyers at higher levels. Why would any sane person buy the ETF at such a high price? Only such an investor who wants to book losses will buy because ETF prices can’t quote very different than that of the underlying for a long time. This seems a case of investors grouping together to jack up the prices higher. Common investors holding the ETF should bail out at these high prices." He adds that the fund house should “issue more shares and create supply to bring down these artificial prices or merge it with a larger scheme".

An active participation of authorized participants is also necessary to create liquidity. “A fund house is supposed to monitor this issue on a consistent basis because it is not ‘best practice’ to see a wide margin between the ETF’s market price and NAV. A responsible authorized participant will also take the benefit and do an arbitrage. But if the gap has widened so much, it appears that authorised participants are not active here," says Hitendra Parekh, dealer and fund manager, Quantum Asset Management Co. Ltd. Justice adds that it is “theoretically only necessary to have a few market makers, but it is much more practical to have well over a dozen. This forces them to compete more aggressively in the arbitrage process." In reality, most ETFs in India have appointed two-three authorized participants. Small corpus sizes, say mutual fund officials, is also one of the key reasons why not many authorised participants are interested.

What should you do?

UTI AMC told us maintaining UTI Sunder is “unviable on account of its tiny size" and it, pending regulatory approvals, aims to merge it with one of their existing index funds. Parekh says that it is also an investor’s lack of knowledge that UTI Sunder’s units get bought; just like when Veena sold her stock in the market. “It is just like some years back when ICICI Prudential’s Spice ETF saw a spike in its volumes and it later came to be known that some investors confused it with that of SpiceJet Ltd, India’s second-largest low-fare airline," he adds.

While tracking error is essential to look at how efficient a passively-managed fund is, one should also look at the deviation between market prices and NAVs in ETFs.

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