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

Curious case of Coal India Futures Pricing

Pricing of a future/forward contract should be based on the dividend that is expected to come and due to the expected dividend, the price of futures is lesser than the spot.

Take the case of Coal India, the underlying quote is available at

http://www.nseindia.com/live_market/dynaContent/live_watch/get_quote/GetQuote.jsp?symbol=COALINDIA

The current market price is 299.9

The company is giving dividend of Rs 29 and the Ex-date is 17th Jan (tomorrow), so the price should fall by 29 tomorrow.

We should expect the futures to trade at discount, but see the futures price here

http://goo.gl/AeuEQi

Futures is trading at 299.75, so there is no impact of dividend at all??

Why - what could be the reason?

The reason is that there is concept of adjustment of the futures price and the strike price of the option in case of large dividend.

Here is what the NSE website state

Link source- http://www.nseindia.com/products/content/derivatives/equities/adjust_in_case_corp.htm

Dividends

- Dividends which are below 10% of the market value of the underlying stock, would be deemed to be ordinary dividends and no adjustment in the Strike Price would be made for ordinary dividends. For extra-ordinary dividends, above 10% of the market value of the underlying security, the Strike Price would be adjusted.

- To decide whether the dividend is "extra-ordinary" (i.e. over 10% of the market price of the underlying stock.), the market price would mean the closing price of the scrip on the day previous to the date on which the announcement of the dividend is made by the Company after the meeting of the Board of Directors. However, in cases where the announcement of dividend is made after the close of market hours, the same day's closing price would be taken as the market price. Further, if the shareholders of the company in the AGM change the rate of dividend declared by the Board of Directors, then to decide whether the dividend is extra-ordinary or not would be based on the rate of dividend communicated to the exchange after AGM and the closing price of the scrip on the day previous to the date of the AGM.

- In case of declaration of "extra-ordinary" dividend by any company, the total dividend amount (special and / or ordinary) would be reduced from all the strike prices of the option contracts on that stock.

- The revised strike prices would be applicable from the ex-dividend date specified by the exchange.

Also, In case of futures contract, the price of the futures contract would be adjusted downward (without loss to the long party)

The closing price of Coal India on 14th Jan was Rs 288.9 => 10% of 288.9 = Rs 28.89, if you round off it would be Rs 29. So, this is considered as a special dividend.

If the dividend had been even Rs 1 lower, then it would not be special dividend.

Spot Prices 

Price of futures contract

On 14th Jan EoD futures price is - 276.05

Which is around Rs 14 lower than the spot, It means that market was expecting that the dividend would be around this range. But due to higher dividend, the futures price increased on 15th Jan.

Futures opened at Rs 300 and closed at Rs 295.90

Stock opened at Rs 301 and closed at Rs 295.20

So, futures went into contango from backwardation. Those who were long in Futures would have made a kill.

These are the uncertainty in the market.

Also, what if they had chosen Rs 28 as the dividend - then the futures price would have depressed more!!

Interesting point to note is that the Futures price did increase towards the end of 14th Jan and the dividend announcement was done after the market hours. 

Was somebody leaking the information to few folks? 

Insider information and trading can't be ruled out in this case.

Thanks

Ratan

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