International ETFs are trading at premiums. What should investors do?

The regulatory stranglehold

The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) have implemented guidelines that impact international investment opportunities. Mutual funds are restricted to investing only $7 billion in foreign equities and $1 billion in international ETFs. These restrictions, virtually unchanged for nearly a decade, have created a constriction in the global investment channel.

The premium paradox

The most alarming aspect is the unprecedented premium at which these ETFs are trading. These funds are trading at premiums ranging from 15% to 20% above their net asset value (NAV).

The question is how to know if the ETFs are trading at a premium. One way is to compare their indicative NAVs (iNAVs) with their market trading prices. The NAVs for ETFs are published daily on the Association of Mutual Funds in India (Amfi) website, while the iNAVs are updated frequently during market hours. This can be found on the specific ETF pages on exchange websites. 

For example, to check if an ETF like the Motilal Oswal NASDAQ 100 or the Mirae Asset Bank Plus ETF is trading at a premium, compare its iNAV from the exchange website with the price at which it is being traded in the market. The difference between the trading price and the iNAV indicates whether the ETF is trading at a premium (if the trading price is higher) or a discount (if the trading price is lower.)

Typically, ETFs are designed to track their underlying assets through an arbitrage mechanism closely. Professional market makers and authorized participants normally create or redeem ETF units to maintain price alignment with the underlying securities.

However, the current market situation has disrupted this delicate balance. The regulatory constraints have effectively frozen the creation of new ETF units, creating artificial scarcity. This scarcity leads to a supply-demand imbalance where existing units become disproportionately expensive. And this premium erodes potential returns.

But why are investors increasingly turning to overseas ETFs?

The post-election market surge

The recent US election results have sparked significant interest in international markets through multiple compelling avenues. Technological innovation stands at the forefront, with the Nasdaq 100 representing a concentration of cutting-edge tech companies that offer exposure to leaders in artificial intelligence (AI), cloud computing, and overall digital transformation. Investors are increasingly recognizing the potential of tech-heavy indices.

Moreover, the desire for global diversification has become paramount as investors seek opportunities beyond domestic markets to mitigate local economic risks.

Distributors have reported a massive demand for international funds, with investors showing a particular preference for Nasdaq 100 ETF due to its broad exposure to US markets. However, this enthusiasm comes with a critical caveat—the inflated pricing mechanism that’s currently in play.

The Liberalized Remittance Scheme: A strategic alternative

The LRS offers a strategic alternative for savvy investors. While there is a 20% tax collected at source (TCS), this approach presents nuanced opportunities that merit careful consideration. The TCS is not a final tax but a collection mechanism that can be claimed as a credit during income tax filing, potentially offering significant advantages.

Investors can effectively offset this against their total tax liability, which may ultimately make it more cost-effective than paying the high ETF premiums. The LRS provides direct access to international markets, allowing investments of up to $250,000 annually with greater flexibility than domestic ETFs.

Investors holding ETFs with premiums exceeding 15% should reconsider their position. The most prudent approach would be comparing the total cost of LRS investments versus premium-laden ETFs, potentially leveraging the tax credit system.

A word of caution

This entire analysis isn’t about creating fear or panic. It’s about understanding the nuanced landscape of international investments. Many investors are jumping in blindly, attracted by the glamour of international markets. True investment success comes from understanding, not following. When the market price of an ETF eventually converges with its NAV, the returns will normalize, potentially catching many off-guard.

The international investment landscape is not static. Regulatory environments will evolve, market sentiments will shift, and new opportunities will emerge. The most successful investors will be those who stay informed, remain flexible, and approach investments with a strategic, analytical mindset.

After all, in the world of investments, knowledge isn’t just power—it’s protection.

Arihant Bardia is the founder and CIO at Valtrust Capital.