Case 021Index funds, ETFs and passiveCore
During a sharp gold rally, an AMC's gold ETF trades 2.1% above its indicative NAV. A client wants to buy Rs 5 lakh through the exchange today. What is the price doing, what does he lose if the premium closes, and what are the alternatives?
1The situation
Gold has risen about 8% in ten trading days. The gold ETF of Kanchanjyoti Mutual Fund, an invented AMC, has risen more: its units trade on the exchange at 2.1% above the indicative NAVThe value of the gold each ETF unit holds, published through the day from the live gold price, so buyers can see what the unit is worth against what it trades at. the AMC publishes through the day. A client calls his adviser: he wants to put Rs 5 lakh into the ETF this afternoon before gold goes higher.
The AMC also runs a gold fund of funds that invests in the same ETF and sells units at NAV, with an extra expense of about 0.15% a year on top of the ETF's own cost.
2Your task
Explain to the client what the 2.1% premium is, what it costs him if it closes, and what else he could do.
Quick check
If the client buys Rs 5 lakh of the ETF at a 2.1% premium and the premium then closes to zero with gold unchanged, roughly what does he lose?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The price has run ahead of the gold: he would pay Rs 5 lakh for units holding about Rs 489,716 of gold, and if the premium closes he loses about Rs 10,284 with gold unchanged. ETF units trade at whatever buyers will pay, and in a rush the creation of new units cannot keep up. The alternatives are the fund of funds at NAV, a limit order near the indicative NAV, or buying in parts over a week.
Step 1Why can an ETF trade above the gold it holds?
A concert ticket has a face value and a resale price, and on the night of a sold-out show the two part company. An ETF unit is a claim on a fixed amount of gold, but on the exchange it trades at whatever the next buyer will pay, and in a rally buyers outrun the supply of new units. New units are created when a large dealer delivers gold to the fund, and that takes time: sourcing, delivery and settlement. Until the new supply arrives, impatient buyers bid the price above the value of the gold inside, which is the premiumThe amount by which an ETF unit trades above the value of the assets it holds; the opposite is a discount.. The AMC publishes an indicative NAV through the day so that buyers can see the gap, and today it is 2.1%.
Step 2What does the premium cost him?
Separate the gold bet from the premium bet, because he is making both. Rs 5 lakh at 2.1% above NAV buys units holding about Rs 489,716 of gold. If gold stays flat and the premium closes, which it does once new units are created, he has Rs 489,716: a loss of about Rs 10,284 on a gold price that did not move. If gold rises another 3% and the premium closes, his units are worth about Rs 504,407, a return of about 0.9% instead of 3%. The premium does not have to close today, and in a long rally it can widen first; the point is that it is a separate risk he is not being paid for.
| What happens next | Gold | Premium | His Rs 5 lakh becomes | Return |
|---|---|---|---|---|
| Premium closes, gold flat | 0% | 2.1% to 0 | Rs 489,716 | -2.1% |
| Gold rises 3%, premium closes | +3% | 2.1% to 0 | Rs 504,407 | +0.9% |
| Gold rises 3%, premium stays | +3% | unchanged | Rs 515,000 | +3.0% |
| Bought at NAV through the fund of funds, gold rises 3% | +3% | none | Rs 515,000 | +3.0% |
Step 3What are the alternatives?
Three, in order of how much of his urge they satisfy. The fund of funds buys at NAV, so no premium, at the cost of about 0.15% a year extra and a day's delay on the price. Over five years that extra cost is about Rs 3,761, well under the Rs 10,284 premium he would pay today, and it takes about 14 years of the higher expense to equal the premium. A limit order on the ETF at or just above the indicative NAV may fill on a quieter afternoon, and may not fill at all. Or he buys in five parts over a week, which averages the premium rather than removing it. Say the limits: the fund of funds has its own expense and a one-day price lag, and tax treatment of gold funds has changed before, so confirm the current rules.
Step 4What do you say to the client?
Give him the number, not a lecture. He wants gold at today's price; he can have it through the fund of funds at NAV, and what he would be paying extra on the exchange is about Rs 10,284 for the privilege of settling two hours sooner. The honest framing is that the exchange price contains a crowd, and he can own the gold without buying the crowd. If he insists on the ETF, the limit order near indicative NAV is the compromise, with the warning that it may not fill if the rally keeps going. Either way, note the conversation: an adviser who lets a client pay a known premium without saying so has not done the job.
Where candidates lose it
The common loss is treating the ETF price as the gold price. The interviewer wants to hear that an ETF unit has a value, the indicative NAV, and a price, and that the client is about to pay one for the other.
The second is dismissing the premium as small. On Rs 5 lakh it is about Rs 10,000 that gold has to earn back before the client is level, and for a client who wants gold as a safe asset that is the wrong way to start.
What the interviewer asks next
- Why do gold ETFs show larger premiums in a rally than an index ETF on large cap shares?
- The ETF trades at a 1.5% discount three months later. What does that tell you, and is it a buying opportunity?
- How would an authorised participant close this premium, and what stops them doing it faster?
Company names and figures are illustrative.