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Double whammy: The implications of ETF mispricing

Significant ETF mispricing can have implications for your overall returns, especially amid subdued markets

Double whammy: The implications of ETF mispricing

The Indian equity markets witnessed one of their most brutal falls in March. Amid this, exchange traded funds (ETFs) also began showing erratic movements. For a brief period towards the end of March, the difference between the traded prices and the underlying NAVs of ETFs surged to 10-15 per cent or even more (see the graph below). Generally, ETF prices are closely aligned with their NAVs on a day-to-day basis. That holds true at least for the bigger ETFs, which generate reasonable trading volumes. While the graph shows four prominent ETFs, a similar trend was visible across other ETFs as well.

What caused it
A confluence of certain factors may have led to this. For one, there was a rise in demand for ETFs around that time as some investors, particularly high-net-worth ones, flocked towards them, given the uncertainty created by COVID-19.

Secondly, market makers or authorised participants (APs), who are responsible for maintaining liquidity in ETFs, weren't working at their full capacity as they were adjusting to the work-from-home environment amid the lockdown. That caused a supply-demand mismatch for a short phase.

Lastly, APs were quoting higher spreads on the ETFs, given the uncertainty in the markets.

Why does it matter?
While this was a short-lived phenomenon, the price at which you can buy or sell an ETF is always subject to the market forces of demand and supply. Therefore, such instances of huge mispricing cannot be ruled out going forward. Though rare, they do hurt those investors who end up investing at very high prices. Think about an investor who ends up paying 15 per cent more than the worth of the underlying portfolio. At a time when equity markets are already reeling, further loss due to overpaying greatly adds to the woes of an investor.

Can one avoid this? Since NAVs are only available at the end of the day, comparing the trading price with them is only possible when the trading day is over. Hence, that's not very helpful. But what an investor can do is to compare the day's movement in the price of the ETF with that of the index which it tracks. Ideally, the prices of both should move in tandem. For instance, if the Nifty 50 index is up 2 per cent on a particular day, an ETF tracking it should also be trading about 2 per cent higher. But if you see the ETF up by much more than that, that's your cue to the potential misalignment in its pricing. Avoid investing at that price.

What if you find the ETF trading at a deep discount to the underlying index? Well, you've just got lucky