Zaks Investment Advisory Service

Arbitrage, Exchange-Traded Notes, and Indian Stock Investments

Today, we will conclude our review of the Indian economy and financial markets. At the end of our last program, I mentioned that despite all of its reforms, India remains one of the most bureaucratic countries in the world. One of the areas where this is felt quite strongly is the financial markets. Although foreign capital investments are allowed, they remain strictly regulated. It is very difficult to organize a financial company that could buy shares on an Indian stock exchange on behalf of foreign investors, which, of course, is precisely how investment funds operate. Moreover, these rules often change, and these changes directly affect US investors.

One interesting example of this is the so-called exchange-traded note (ETN), which was created by Barclays bank to offer investors an opportunity to participate in Indian markets. Just a few words about exchange-traded notes: They are very similar to exchange-traded funds. Most investors buy and sell them on the stock exchange. Usually, exchange-traded notes, just like exchange-traded funds, are traded at very near their net asset value. This happens because arbitrage keeps the market price and the net asset value largely in line. Arbitrage represents an opportunity to earn money without any risk. We talked about this phenomenon in one of our previous programs. According to exchange-traded note trading rules, investors may buy and sell them directly through the issuing bank at the note’s net asset value. This may only be performed in large blocks, which means that this is done primarily by large financial institutions rather than individual investors. Here’s how it works: if the stock exchange prices end up being too high compared to the net asset value (NAV), companies buy the exchange-traded notes from the issuing bank at the net asset value and then immediately resell them on the exchange at the higher price, thus earning a profit without assuming any risk. If the stock exchange prices are much lower than NAV, financial companies buy the ETNs and then immediately sell them to the issuing bank at the net asset value. This mechanism prevents the price of exchange-traded notes to diverge from the net asset value.

In this respect, they differ from closed-end funds. I previously mentioned that stocks of closed-end funds sometimes trade above their net asset value (which is called “at a premium), and sometimes below it (“at a discount”). From an investor’s standpoint, this is a fairly unpleasant occurrence: one could buy a fund when it is sold at a premium and lose money even if the price of the stocks making up the fund remains the same. This could happen simply if the fund itself is now being traded at a discount.

But let us get back to Indian securities. Barclays set up its exchange-traded notes so that they would correspond to a particular index of Indian companies. The price of these ETNs was meant to closely track the index levels.

But this ETN underwent a metamorphosis. What happened is that in October 2007, the Indian agency involved in market oversight (something resembling our Securities and Exchange Commission) decided to restrict the rules allowing foreign investments in Indian securities. They did this in order to prevent a further strengthening of the national currency, the rupee. Implicitly, this decision also hurt Barclays since the bank was no loner able to trade Indian stocks. As a result, it was forced to discontinue its purchases and sales of ETNs at their net asset value in the US. Arbitrage opportunities vanished and the Indian ETN was instantly transformed from a genuine exchange-traded note into a closed-end fund, with all of the ensuing consequences. At first, the notes began trading at a premium, and quite a hefty one at that: by the end of 2007, it reached nearly 30 percent. Then, the prices crept down closer to their net asset value. A few weeks later, they were already being traded at a five-percent discount. Between January 14 and March 27, 2008, the Indian stock market dropped by 23 percent. But over the very same span, Indian ETN investors lost 41 percent! I hope that relatively few people bought their Indian ETNs on January 14 and sold them two-and-a-half month later. Most emerging market investors usually purchase stocks for the long term. The people who bought their Indian ETNs one year ago have earned a 40-percent profit despite the losses witnessed over the past two and a half months. But in either case, this episode reminds us of the additional risks inherent to emerging market investments.

At the end of January 2008, the WisdomTree company took heed from Barclays’ experience and organized a real exchange-traded fund. These securities were issued on the back of permission from Indian authorities for WisdomTree to freely buy and sell Indian stocks, as need be. So now, investors have an opportunity to purchase India-linked ETF without fearing premium and discount price fluctuations.

Regular closed-end funds are also available to investors: one was created by Blackstone (IFN), another by Morgan Stanley (IIF). Open-end funds are also at hand – for example, one from Eaton Vance. And as always, one may also purchase Indian company ADRs that were issued on the US exchanges: these include ADRs from Tata Motors, which has just purchased Jaguar from Ford, along with several large banks, energy and computer companies.

We have now concluded our overview of four emerging nation markets that Goldman Sachs designated into a special group it called BRIC. Next time, we will try to answer two interesting questions: what are the odds that these nations’ markets will continue to grow, and are there other markets out there that Goldman Sachs failed to mention but which still might be of interest to us. But with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.