ETF - Discounts to NAV - how large can it be?

India Infoline Mutual Fund has an ETF on NIFTY.

This ETF has been trading at a huge discount to its NAV. 

I have taken the prices and NAV for yesterday (15th Jan) and today (16th Jan)

15th Jan data (it is at the near the end of the day - low volume is see - but bid-ask is not that wide)

16th Jan data (note that it is at the start of the day - so low volume is seen and also bid ask is wide)

The question is that it is trading at roughly @10% discount to its NAV. Why don't people take advantage of it.

For every ETF, authorized participants can trade the underlying in the market and create the ETF units, why is it the case they are not exploiting the arbitrage.

There are some challenges to the arbitrage

1. The issue is the liquidity, to exploit the arbitrage here, you will have to buy the ETF from the market and surrender to the authorized participant.

The creation unit size is 5000 units. So, you need to buy 5000 units from the market and then deposit to the authorized participant. Naturally at this liquidity, it will take at least 1-2 month to buy that quantity from the market without impacting the prices.

Link to shceme document - http://www.iiflmf.com/Portals/0/IIFLMF/downloads/IIFL%20NIfty%20ETF_SID_Updated%20Sponsor.pdf

See the creation unit detail in the document.

Risk factor regarding this has been specifically mentioned in the scheme information document (SID), i have taken the relevant ones

"Investors should note that even though the Scheme is an open ended Scheme, subscription/redemptions directly with the Fund would be limited to such investors who have the ability to subscribe/redeem the units of the Scheme in specific lot sizes. Generally, these lot sizes are larger as compared to normal funds. Even though this Scheme is open ended due to large lot size, very few investors can directly subscribe and redeem the units of the Scheme. However, investors wishing to subscribe/redeem units in other than specific lot sizes can do so by buying/selling the same on the Stock Exchange unless no quotes are available on the exchange for 3 trading days consecutively"

So, if for 3 days if this ETF dont get traded in the exchange then we can redeem any units - but i dont think that is going to happen.

2. One more reason is that IIFL is charging 5% markup for creating/redeeming, this creates unnecessary cost and removes arbitrage opportunity 

see the below excel

http://goo.gl/4JBFu0

This is disclosed in the SID 

Ongoing Price for redemption (sale)/switch out (to other schemes /plans of the mutual fund) by investors. Computation of load 

Authorized Participant and Large Investor can redeem units directly with the fund at  Applicable NAV based prices, subject to applicable exit load; if any. There is no exit  load currently. However transaction charges payable to Custodian/ Depository  Participants, and other incidental charges relating to conversion of units into basket of securities may be deducted from redemption proceeds. The charges will be notified on www.iiflmf.com from time to time. Investors other than Authorised Participant and Large Investor may redeem units at the listed price plus transaction handling charges on stock exchange. As required under the Regulations, the Fund will ensure that the Redemption Price is not lower than 93% of the NAV and the Purchase Price is not higher than 107% of the NAV, provided that the difference between the Redemption Price and Purchase Price of the Units shall not exceed the permissible limit of 7% of the Purchase Price, as provided for under the Regulations.

So - the fund can give you 93% of the NAV as per the rule. So, essentially the discount is not 10% - it can be only 3% which is not much for participants and hence we are seeing so much discount.

Rules should be modified to ensure that arbitrage can be efficiently done and the products are priced efficiently in the market.

I don't understand the reason for 5% markup or how come the redemption price can be around 7% lower than the NAV?

Liquidity is low because ETF demand in India is still very low - but should not the APs provide liquidity in the market, this can be done only if these exorbiant charges by Asset management companies (AMC) are reduced. 

So, these AMCs are also to be blamed for low liquidity in the market.

IIFL NIFTY ETF looks like a very low cost product (current expense ratio of 0.25%) but is it in reality?? What about the transaction cost etc.

ETFs can have big future in India - Only thing the investors want is liquidity and efficient pricing. 

When we will get that?

Disclosure - I am long in this ETF.

Thanks

Ratan