So, why are these ETFs trading at a premium, how does this impact investor returns, and what alternatives exist to avoid overpaying? Let’s break it down.
Why Are International ETFs Trading at a Premium?
The primary reason behind the price distortion is regulatory restrictions. The Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) impose strict limits on overseas investments by mutual funds. According to these guidelines, Indian mutual funds can invest a total of $7 billion in foreign equities, with a separate sub-limit of $1 billion for international ETFs. These caps have remained unchanged for nearly a decade.
These limits were reached in 2022, leading SEBI to instruct asset management companies (AMCs) to stop accepting fresh inflows into these ETFs. While existing ETF units continue to trade on the stock exchange, AMCs can no longer issue new units to meet fresh demand. This creates a supply crunch while investor interest continues to grow, causing ETF prices to exceed their NAVs.
The Impact of Premiums on Returns
An ETF’s price should ideally align with its NAV, which represents the aggregate value of its underlying assets. However, the demand-supply mismatch has led to substantial price premiums, impacting investor returns.
For example, if an ETF has an NAV of Rs 100 but trades at Rs 115, new investors must generate an additional 15% return just to break even. This premium effectively reduces potential gains and exposes investors to heightened downside risk if ETF prices correct.Currently, all six international ETFs in India are trading at a premium:
The Risks of Buying ETFs at a Premium
Historically, ETF premiums have stayed within a 5% range, but recent demand surges have pushed them to uncomfortable levels. While some ETFs may see their prices and NAVs converge within days, others might take up to 240 days. In most cases, price convergence happens within a year, meaning investors who bought at a premium could suffer losses in the short term.
How to Track and Avoid ETF Premiums
To avoid overpaying, investors should compare an ETF’s trading price with its indicative NAV (iNAV), which reflects the real-time value of its underlying holdings. Fund houses update iNAVs frequently on their websites and stock exchanges like the BSE.
If an ETF’s trading price consistently exceeds its iNAV, it’s a clear indication that the fund is trading at a premium. In such cases, investors should reconsider their entry points or use limit orders instead of market orders to avoid overpaying.
A Smarter Alternative: Investing Directly Through LRS
For investors looking to bypass these ETF premiums, a viable alternative exists: direct overseas investment through the Liberalized Remittance Scheme (LRS). Under LRS, Indian investors can remit up to $250,000 per year to invest in global markets.
By investing directly in US-listed ETFs or stocks, investors can avoid paying inflated premiums and ensure their purchase price closely matches the actual value of the assets. This approach not only improves potential returns but also provides greater flexibility in asset selection.
Should You Avoid International ETFs?
Despite their drawbacks, international ETFs remain a convenient way to gain exposure to global markets. However, investors must be cautious when premiums are high.
If you choose to invest through ETFs, consider:
- Using limit orders to avoid overpaying.
- Monitoring regulatory updates, as an increase in SEBI’s overseas investment limits could reduce ETF premiums in the future.
- Waiting for price corrections or exploring direct investment via LRS.
Final Thoughts
The current premiums on international ETFs highlight a key challenge in global investing—regulatory constraints creating artificial supply-demand imbalances. While ETFs offer an easy route to diversification, their inflated prices reduce returns and increase risks. Investors should carefully assess NAV premiums before buying and explore direct investment options through LRS for a more cost-effective approach.
In investing, knowledge is power. By understanding ETF premiums and NAV convergence, investors can make informed decisions and maximize their global investment potential without unnecessary costs.
(The author of the article is Viram Shah, Founder & CEO, Vested Finance)
Source: Why international ETFs are trading at a premium and how investors can avoid overpaying
