RamaKrishna Vadlamudi

19 March 2014

http://ramakrishnavadlamudi.blogspot.in/

No for CPSE ETF! High Concentration Risk to Public Sector Firms About 60% Exposure to 4 Stocks in Oil & Gas Sector Big Political Risk in the form of Policy Logjam No Downside Protection Against the Principles of Diversification

Investment Case Against CPSE ETF:

If you invest in this ETF, your money will be vulnerable to concentration risk. This ETF invests in stocks of only 10 companies. Tracking the CPSE index, about 60% of your money will be deployed in only four stocks, namely, ONGC, Gail India, Oil India and Indian Oil Corporation. All these four stocks belong to oil & gas sector. The first three companies have been bearing subsidy burden of governments oil marketing companies (OMCs)BPCL, HPCL and IOC for several years. All these companies are owned by Government of India (GOI). The ETF performance will depend on the whims and fancies of ruling politicians and bureaucrats. With only 10 stocks, we cannot call this ETF a diversified fund. Having only 10 stocks, that too all from the public sector, in an ETF is completely against the principles of diversification. An ETF is basically an investment vehicle that pools money, invests in a basket of securities and trades like a stock on a stock exchange. When it comes to corporate governance rules, GOI has got a poor track record. Quite often, governments actions are not guided by the interests of minority shareholders. In the past they have used public sector companies to meet their own political interests. Recently, GOI has been encouraging cross holdings among public sector companies. A few days back, ONGC and Oil India picked up 10% stake in IOC. LIC of India has been buying stakes in BHEL, ONGC and others at the behest of GOI. Such arm-twisting on
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19 March 2014

the part of GOI is not good for LIC policyholders also. This will complicate the valuation of public sector entities and it is not in the interests of minority shareholders of PSUs. In the last few months, GOI has forced Coal India (about Rs 16,500 crore), NMDC and public sector banks to declare large dividends to fill up its coffers, instead of allowing the companies to invest in profitable avenues. This ETF will bear a lot of political risk. Government is very weak in setting policies and implementing them effectively. Though some form of autonomy is given to PSUs, overall control is done by respective ministries. The overall management of these companies continues to remain weak despite the companies having some inherent strengths. Most of the companies in the CPSE index are from natural resources sector. This sector has been imperiled by lack of environmental clearances and regulatory risks. Even though Coal India is a monopoly, it is bedeviled with fuel supply agreements, imposed by the Government.

Features:
The Composition of CPSE Index:
Company Name Oil & Natural Gas Corp GAIL (India) Ltd Coal India Ltd Rural Electrification Corp Oil India Ltd Source: GSAM Sector Energy Energy Metals Financial Servcs Energy Weight % 26.72 18.48 17.75 7.16 7.04 Company Name Indian Oil Corp Power Finance Corp Container Corp of India Bharat Electronics Engineers India Sector Energy Financial Servcs Services Manufacturing Construction Weight % 6.82 6.49 6.40 2.00 1.13

The CPSE ETF is managed by Goldman Sachs Asset Management (GSAM). This is an open-ended exchange traded fund. The new fund offer (NFO) for retail investors opened on 19 March 2014 and closes on 21 March 2014. The scheme will be listed on the BSE/NSE next month. After listing on BSE/NSE, investors can buy and sell these units throughout the market hours through their trading account with a broker, just like they trade any listed stock. The ETF will track the CPSE index. Entry and exit load are nil. Minimum amount of subscription is Rs 5,000 per application for retail investors.

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19 March 2014

The GOI wants to raise a maximum of Rs 3,000 crore through this ETF from retail and other investors. The GOI proposes to allot units at a 5% discount during the NFO. Moreover, it proposes to give, after one year, bonus units for those who invested in the NFO and stayed with their units for at least one year. The scheme is in compliance with the Rajiv Gandhi Equity Savings Scheme (RGESS), which has tax deductions subject to certain conditions. As the ETF units are traded like stocks on exchanges, adequate liquidity is available for retail investors having demat accounts. The expense ratio of the fund is 0.49%, which is very low compared to other ETFs available in India.

Return Expectations:
How much return can one expect from this ETF? As you are aware, stocks do not offer any guaranteed return. Returns are a function of companys business prospects, investor sentiment and liquidity in stock markets. Foreign institutional investors (FIIs) are big investors in Indian equities. Of late, they have been showing preference to invest more in private sector companies rather than PSUs. At present, investor sentiment is generally upbeat about Indian equities. Given that public sector companies are good in paying dividends, PSUs enjoy dividend yields of up to 4%, much higher than their private sector counterparts. The PSUs may not go bankrupt given the governments implicit sovereign guarantee, but the GOI may allow certain companies (e.g., Air India, BSNL) to bleed as long as possible. Even with schemes like US-64 that was run by the then state-owned and unregeulated Unit Trust, investors lost heavily. However, as happened in 2008 and 2009, PSUs with good balance sheets typically do well when stock markets are afflicted with global crises. There is this narrative going round that one can buy these units in NFO and sell them after one year to earn a return of about 11 percent without any risk. My question is if everybody wants to sell these units after one year, who will buy from you? Remember Reliance Power IPO during the 2008 stock market peak when investors and speculators lost heavily in the IPO because everybody wanted to sell and there were no buyers?

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19 March 2014

Why an ETF with only 10 stocks?

Its strange that the capital markets regulator SEBI allowed an ETF to be floated with just 10 stocks. Is it because as an arm of the GOI, they cannot say no to the all-powerful state? Ive a rhetorical question, will SEBI allow an ETF to be launched with just 10 stocks in the private sector? Even insurance regulator IRDA allowed insurers to invest in this highly concentrated ETF. Its very strange that the regulators want to be a party to the governments efforts to raise money for their fiscal profligacy. Why cannot the GOI introduce an ETF that consists of 30 or 60 PSU stocks from a variety of industries and sectors?

Final Words:
Reports suggest that anchor investors invested about Rs 850 crore in this ETF fund yesterday. Institutional investors have sophistication and they are supposed to be masters in risk mitigation. What is suitable for them may not be suitable for retail investors. The CPSE ETF has completely failed as an investment case when you consider the principles of risk mitigation and diversification. The fund is not adequately diversified to provide any cushion during market meltdowns. The concentration risk is very high and non-sophisticated investors may find the fund too risky for their equity portfolios. But I would like to add that Im not telling you not to consider the stocks of PSUs individually. Depending on your risk appetite and portfolio management perspective, you can definitely consider individual PSU stocks provided youve done your own research on these companies and theyre suitable for your investment objectives and goals. While evaluating, please take into account all your investments direct equities, equity mutual funds and ULIPsas a total package. My sincere view is that investors should allocate money towards equities as per their long-term financial plan, asset allocation and risk profile. Making individual investments ignoring the fundamental principles of personal finance will not help you. You should not be solely guided by tax benefits or sops (like 5% discount and bonus units in this case) while making serious investments.

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19 March 2014

While making investments, first see if you have any surplus money, whether the investment offers any return, convenience, liquidity and downside protection. The bottom line is that the CPSE ETF does not offer any diversification, nor does it offer any downside protection. Unsophisticated retail investors are better off with time-tested index funds, tracking Nifty 50, Junior Nifty or BSE 200 index or some large-cap well-diversified mutual funds with long-term track record that are available in the market.

Related Articles:
Understanding Asset Allocation How to invest in Nifty BeES? How to invest in Junior Nifty BeES?
Notes: CPSE ETF Central public sector enterprises exchange traded fund GOI Government of India GSAM Goldman Sachs Asset Management NSE National Stock Exchange SEBI Securities and Exchange Board of India, the capital market regulator PSU Public sector undertakings or public sector enterprises or state-owned enterprises ULIPs Unit-linked insurance plans that typically invest in stocks Disclosure: Dont own any shares in the above stocks. But I own certain shares in a few PSUs. Disclaimer: The information provided is only for information purposes and should not be construed as investment advices. Investors should consult their own financial advisers before making any investments. The author is an investment analyst with a vested interests. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/ http://scribd.com/vrk100

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