The CPSE Exchange-Traded Fund’s recent follow-on fund offer (FFO) successfully raised 17,000 crore for the government. While the upfront discount of 4.5% to the reference price was a bait for investors, it also played up the market leader status of the constituents, attractive valuations of the segment  and low correlation relative to the broader market to garner investor interest. Do these make the ETF an attractive investment?

Portfolio

The CPSE ETF portfolio comprises 11 PSE stocks across giant, large- and mid-cap segments. This includes NTPC Ltd, Indian Oil Corp. Ltd, Coal India Ltd, and other ‘Maharatnas’, ‘Navratnas’ and ‘Miniratnas’ of central public sector enterprises (CPSE). Along with the concentration of ownership with the government, the stock and sector concentration limits in the portfolio is also high with a cap of 20% on individual stocks and no limit for sector exposure.  In comparison, the Bharat 22 ETF, which like the CPSE ETF was used by the government to disinvest its holdings, has a cap of 15% in each stock and 20% in a particular sector.

The CPSE ETF's portfolio is currently concentrated in the energy sector with power, oil and petroleum products accounting for over 60% of the portfolio and  the top 5 stocks accounting for 82.5% of the portfolio making the fund's returns vulnerable to the poor performance of the dominant sectors and companies. 

Performance

As an ETF, the fund’s returns have closely tracked the performance of the index, NIFTY CPSE TRI. As on 4 December 2018, the fund generated 3.78% for a 3-year investment horizon, -19.83% over 1 year and -21.59% year-to-date. Given the portfolio construction, the theme for this fund could be best described as a combination of PSE and energy sectors. 

The government-owned companies are not wealth creators. There will always be a socialist angle to the decision making which may not always be in the shareholders’ interest- Gajendra Kothari, MD and CEO, Etica Wealth Management Pvt Ltd

In 2015 and 2017, CPSE ETF  returned -14.28% and 19.36%, respectively, below the PSE category average of -7.62% and 21.68%. It performed marginally better in 2016 with returns of 17.43% compared to 17.2% from the PSE category average. The comparison with funds in the energy theme is also not favourable for the CPSE ETF with the sector significantly out-performing with 0.15% return in 2015, 24.19% in 2016 and 39.98% in 2017. Against a broad market index such as the Nifty 50 TRI too the CPSE ETF has been unable to hold its own. The Nifty 50 TRI outperformed in 2015, 2017 and 2018 with returns of -3.01%, 4.31, 30.27% and 2.95% (YTD) respectively. But in 2016, the CPSE ETF outperformed the Nifty 50 TRI by 13%. With an uninspiring returns record, the CPSE ETF does not give comfort on the risk metrics either, with the standard deviation at 18.62 being higher than that of the Nifty50 TRI at 14.33 indicating greater volatility. Also, its Sharpe ratio is lower at -0.11 compared to 0.31 for the Nifty50 TRI indicating the fund generated lower returns for every unit of risk taken. 

Prospects

Many of the stocks in the portfolio have seen erosion in prices which has led to better valuations in the form of lower P-E (price-to-earnings) and high dividend yield ratios. The regular payment of dividend is one of the criteria for including stocks in the CPSE index. This along with the low market price of the stocks contributes to the higher dividend yield of this index relative to Nifty 50 and other broader market indices. “The PSU stocks have been on the receiving end as the Nifty PSE index is down 23% in the last 12 months. PSU stocks have been reduced to a dividend play. While there seems little downside from these levels, only select stocks will provide steady returns," says Amnish Agarwal, head-research, Prabhudas Lilladhar Pvt. Ltd.

While there seems to be limited downside for oil marketing companies, crude prices and government policy are major determinants as we are close to 2019 Lok Sabha elections. - Amnish Agarwal, head-research, Prabhudas Lilladhar Pvt. Ltd

The depressed valuation reflects the market’s view on the expected performance of the stocks given the risks associated with government ownership as well as the headwinds facing the dominant sectors in the portfolio. “The government-owned companies are not wealth creators," said Gajendra Kothari, managing director and chief executive officer of Etica Wealth Management Pvt.Ltd. “There will always be a socialist angle to the decision making which may not always be in the shareholders’ interest," he added. 

The energy sector, to which the fund has significant exposure, is sensitive to GDP growth. The below-expectation year-on-year (y-o-y) GDP growth at 7.1% in Q2 of FY19 and the lower GDP growth expectation for FY2019 and FY2020 may not augur well for the sector and the fund. “While there seems to be limited downside for oil marketing companies, crude prices and government policy are major determinants as we are close to 2019 elections. Stable crude prices and consistent pricing policy for petrol and diesel can provide medium term gains," said Aggarwal.

Mint money Take

The fund deals a double whammy of concentration of sector and ownership and this can be seen in its performance.  You don't have to hem yourself into a corner by investing in an ETF where the underlying index is narrowly defined by the CPSE Index. Since government ownership is indispensable in the selection of the components of the index, it excludes sectors that represent the India growth story.

If the ownership structure resonates with you, then there are more efficient ways to take exposure to them.  There are a few actively managed funds that have done a better job of managing returns and risk, albeit at a higher cost, which you can consider when the theme’s outlook improves. Another option is to look at diversified large- and multi-cap funds which take exposure to well managed companies, including PSEs, across sectors.  

According to Kothari, the timing of entry and exit is important. “We believe that diversified equity funds are best suited for long-term, goal-based investing needs of our clients," he said.

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