Mumbai: Retail investors, drawn by the superior returns from international markets compared to local equities in the last year, are rushing to allocate money to mutual fund schemes that bet on overseas equities. Amid the dash to put money in these top performers, they are overlooking a crucial detail: many of these exchange-traded funds are at a 20-25% premium to their current values, leaving them exposed to any sharp reversals.

Currently, many of these schemes do not accept fresh subscriptions because they have hit the central bank’s overseas investing limit for mutual funds. The industry currently operates under a $7-billion limit for international mutual fund schemes and an additional $1-billion window for ETFs. The industry first hit this ceiling in February 2022, and since then, only schemes that haven’t exhausted their individual limits – or those where redemptions have freed up space – have been able to accept subscriptions. This resulted in a sharp spike in demand for ETFs, which are traded like stocks on exchanges – with investors buying them at premiums to their net asset values – the daily prices.

“Retail investors blindly buy ETFs, and there is no attempt to look at the premium or discount to the NAV,” says Chetan Nandani, founder, Prime Care Investments.

Currently, the Nippon India Hang Seng ETF trades at a 21% premium to its NAV, while the Mirae Asset Hang Seng Tech ETF trades at a premium of 23%. The Mirae Asset S&P 500 Top ETF trades at a premium of 18%, the Mirae Asset NYSE Fang+ ETF at 19%, while the Motilal Oswal Nasdaq 100 ETF trades at a premium of 2-3%.

“Overseas ETFs can no longer create new units to meet additional demand. However, since they trade on the exchanges, investors can still buy in the secondary markets,” says Kunal Valia, founder, Statlane – a Sebi-registered research analyst. “This has led to crowding into a handful of overseas ETFs, due to which these ETFs are trading at a premium way higher than the NAV.”

As per data from Value Research, international funds, on average, have returned 28% over the last year, compared with Nifty’s 12.8%.
RBI-imposed overseas limits have kept many US-focused mutual fund schemes shut for fresh subscriptions. While investors can bypass these curbs by using the Liberalised Remittance Scheme to buy ETFs abroad, the route comes with high transaction costs and the added hassle of separate brokerage accounts and compliance paperwork. Another alternative is to buy international funds set up in GIFT City, but the minimum investment of $5,000 makes it accessible only to larger-ticket investors. Investors who bought these international ETFs from the secondary market run the risk of sharp drawdowns if the RBI eventually decides to lift this limit. In such an instance, the lofty premiums on many of these products could evaporate quickly.

“Such investors carry a huge risk. The premium on these funds can disappear overnight if RBI were to increase or open up the limits,” warns Nandani. “If that happens, such investors could see a straight capital loss of 20-25% on these ETFs.”

ET Intelligence Group: A sharp fall in IDFC First Bank‘s stock price on Monday, following the discovery of a fraud at one of its branches, has significantly dented its valuation multiple. While the correction may tempt value-seeking investors, caution must be observed not to fall in a valuation trap. Past examples such as RBL Bank and IndusInd Bank where a financial institution faced similar situations show that the affected lenders struggled to claw back the lost ground and regain higher valuation multiples. In addition, such instances may also affect reputation and depositors’ trust.

In the case of IDFC First Bank, the price-book (P/B) multiple inched up gradually to nearly two over the past three years from around one, aided by improving asset quality. In addition, the mid-tier bank also took efforts to revive its net interest margin to around 6% from under 2% seven years ago by shifting its focus on consumer lending and reducing corporate exposure. This makeover has attracted value investors over the past few years, supporting the stock price. The stock hit a 52-week high of 87 in the first week of January and continued to trade closer to this level in subsequent weeks.

This however changed on Monday when the stock crashed by 16% to ’70 from the previous session’s close. Monday’s closing price was nearly 20% lower than the 52-week high level. The bank’s P/B has shrunk to 1.3, the lowest in over three years. However, investors need to wait before making fresh purchases as the stock is likely to remain under pressure given the possible impact of the latest fraud.

IDFC Bank informed stock exchanges on Saturday about fraudulent activities in accounts linked to the state government at its Chandigarh branch, amounting to ‘590 crore. The Haryana government has de-empanelled IDFC First Bank and AU Small Finance Bank from parking of bank deposits. Outflow of government funds may put pressure on current account- savings account (CASA) of banks at a time when they are still facing slower growth in deposits. Sector experts say, a part of government deposits may move to public sector undertaking banks over the medium term. BSE PSU Bank index rose 1.4% outperforming Sensex’s 0.6% rise on Monday.
“This episode could prompt other states to reassess their comfort with smaller banks,” a banking analyst told ET. “For mid-sized and smaller lenders, the risk of losing state government business has clearly risen after this incident.”

IDFC First Bank has said that recoveries will help cushion the financial impact of the fraud. Analysts, however, caution that recoveries in such cases are typically slow. “If any third party chooses to pursue litigation, the recovery process could be significantly delayed,” the analyst said.
As per the Reserve Bank of India’s circular ‘Provisioning pertaining to Fraud Accounts’, banks are required to provide for the entire amount involved in the fraud. This provisioning can be done immediately upon classification or spread over a period of upto four quarters. For IDFC Bank, if the entire amount is provided in a single quarter, the bank may be forced to report a net loss given that it reported a profit of ‘503 crore in the December quarter.