Premium: Making Money From The Stupidity of ETF Investors?

Sometimes you see a Rs. 100 note on the ground. And you wonder, is it real? If it was real, wouldn’t someone else have picked it up? Or if I bend down to pick it up, will someone steal my wallet? Can I phone a friend or take an audience poll?

Life isn’t a TV quiz, and sometimes you just take out your wallet, pick up the note from the ground and put it inside.

One such “free lunch” is currently on, with the Motilal Oswal N100 ETF. This one invests with the Nasdaq 100 - and is supposed to track it. It does track the N100 (in equivalent rupees) but look at how the traded price is very different from the NAV.

The Basics: How Are ETFs Priced?

You buy and sell a mutual fund from the AMC. The units are bought at NAV, and sold at NAV (there are some loads, but that’s a percentage of NAV, typically).

An ETF is different. You buy from the market. From another seller. And you sell to a buyer. The mutual fund AMC behind the ETF cannot be the buyer or seller, according to the rules.

But an ETF is just a reflection of its holdings. It holds shares, and cannot be valued at higher (or lower) than it’s Net Asset Value (NAV) per unit. So if it’s valuation is Rs. 15 per share, then you pay Rs. 15 per share to buy (if there is a willing seller).

Because the market trades in it’s own way, there may be a buyer at Rs. 15 but the best seller may only be at Rs. 16. How do we resolve this?

The AMC will appoint market makers who buy in large quantities (a “creation unit”) and then sell to buyers in the market. Such market makers may prefer to sell at, say Rs. 15.5 instead, in the example above, narrowing the “gap” between the seller and buyer. His profit is the 0.5 difference.

Such market makers will typically wait for volume to build up in an ETF and make their money in the spreads.

If the market maker is weak, or absent, some people can bid up the price to whatever levels they want. A buyer can decide he will buy it at Rs. 22 instead, and if there is a willing seller, that trade will happen.

Why would you pay MORE than NAV?

We don’t know. We don’t really care, but how can we make money if someone else is being this stupid?

How To Profit From That Stupidity: N100 Version

The book of Motilal’s N100 ETF has the following buyers

This, when the NAV at that point of time was 352.2278. Therefore, if we could buy at NAV and sell at the market, you have a neat 20% profit.

So if you already own this ETF, it’s just better to sell it. There’s a 20% extra profit right there. This is something that should and shall vanish over time. So, if you are holding longs and do not expect Nasdaq to jump 20% in a matter of days, this would be the time to sell.

If you have a chunk of money, maybe there’s way to bridge the gap and make money because some stupid bloke wants to pay 20% more for this ETF.

While the Creation Unit Size of the ETF is 1.20 Crores, Motilal Oswal will sell you units in lots of 100,000 units each. So you need about Rs. 3.4 crores to buy one lot at the NAV.

Then you sell these units, little by little, at the market price which is 20% higher. Over time, you will have sold at 20% more, and recovered your investment. Rinse and repeat until stupidity doesn’t subside.

The Risks: Of course there are risks:

• People that are stupid may not stay stupid forever. If they refuse to buy at stupid levels, then you have no choice but to hold on - because they might only buy at LOWER than NAV, which doesn’t help.

• The NASDAQ could fall. Then the N100 will fall. Even the rupee could rise which will hurt your portfolio in rupees. The market risk remains - and while you can hedge a little, the hedge costs may be quite heavy.

Any Alternative way to Invest in Nasdaq

But what if you wanted exposure to Nasdaq 100 while not being eager to invest 3.5 Crores and want to take advantage of the arbitrage that straight away gives ? While we have no other ETF’s / Mutual Funds that track Nasdaq on the Indian Market.

But if you have a account that enables you to buy stocks / ETF’s in the United States, you can directly buy a ETF such as QQQ.

How has QQQ performed against N100?

The huge gap in returns we observe above is partially due to the depreciation of the Rupee versus the Dollar. While the N100 is denominated in INR, the QQQ is denominated in USD. INR has over the same period depreciated by as much as 50%.

A second factor is that QQQ has a high dividend payout ratio which is not the case with N100 which is yet to declare any dividend since inception.

The Past: The MF IPO Pops

In 1994, Morgan Stanley debuted with its first India fund. Unfortunately investors most of whom had no understanding of what a Mutual Fund applied massively since it was from a very well known US financial institution and what more, was being sold at par. Pre listing kerb deals too took place at prices way higher than par. It got listed around 9 (Face Value of 10) since issue expenses were removed from the fund at the beginning.

While we have come a long way from that start, the fact that a liquid fund like the N100 still trades at a premium to the NAV signifies that market isn’t really as efficient as we think it is. But that also is a opportunity for those who are able to spot such moves and take advantage of the same.

Remember: mutual funds aren’t companies. They are just the sum of the stocks they hold. Valuing them at anything higher than that is insanity.