Will There Be Takers For A PSU ETF?

This week the government stepped up its divestment drive by offering a 4 % stake in Hindustan Copper. NTPC, Oil India and NMDC are likely to be next. The government will most likely use the well accepted OFS or Offer For Sale route. But that will certainly not be enough to reach the Rs 30,000 crore target. Another route under serious consideration is the creation of a PSU ETF or exchange traded fund. ETFs have proved to be a popular instrument in the recent past but a previous similar attempt by the government 20 years ago had failed. Sajeet Manghat and Payaswini Upadhyay find out what the government should do to get it right a second time around.

For Prime Minister Manmohan Singh and his men, time is running out. Investor interest in the country has been dampened by a slowing economy, and with a widening fiscal deficit, the government urgently needs to get its disinvestment drive in gear. One of the means that the department of disinvestment wants to use is a novel Exchange-Traded Fund or ETF route.
Experts say this ETF idea may work better than the bundling strategy the government employed between 1991 and 1995, when it raised over Rs 9,793 crore by divesting stake in 30 companies.
The problem then, was that the government created mixed bundles of Central Public Sector Enterprises to ensure that both the attractive and the no-so-attractive stocks saw some demand... And when these bundles were sold to GIC, LIC and UTI, these financial institutions could not discover the fair value of each PSU stock.
The problem did not end there. UTI, for instance, which picked up 65 percent of this issue, then distributed the shares to its various schemes including UTI Master Growth and US-64... and in 1992, when the markets crashed, UTI had to be bailed out by the government. Sanjiv Shah
MD & Co-CEO, Goldman Sachs Asset Management
"When you look at the structure- a mutual fund structure- and the divestment that we enumerated in the early 90s, it is not linked to the underlying prices. It is a divestment, possibly done without the price discovery of the institution. What a ETF does is, it is always linked to the underlying stock which are always listed on the market. What you have is a pricing which is a very-very transparent, very-very available to the people. So when people are into an ETF, they know exactly what they are buying and then can easily convert into underlying components of that. So they are completely different models in that sense."
Experts say that the Indian government may want to take a peek at the Hong Kong government's playbook, which has executed this PSU ETF idea successfully. After the Asian meltdown in 1997, the Hong Kong government acquired substantial stakes in listed companies to support the markets, created a Hong Kong Tracker Fund to hold these stakes... and then divested its holdings in November 1999 through a 4.3 billion dollar IPO of the Tracker Fund. Han Ming
Partner- Capital Markets, Clifford Chance
"If you look at the structure, on the left hand side was the government - holder of these securities- and it was looking at a vehicle in which it could divest into. It could obviously proceed to do it by way of selling it into the market but that would have had a direct impact on the performance of the securities on the public securities market. So then what it did was, it invested in an ETF which is your HK unit trust. The AMC had to first set up the fund and they had to constitute a HK established unit trust - once the HK established unit trust was set up, it could then purchase and acquire the securities directly from the government. Once that acquisition was made and therefore the assets moved from the government to the HK unit trust, the trust- by way of the AMC registering and listing the unit trust- was then effectively IPOed on the exchange."
Back home, the government has taken the first step by appointing ICICI Securities as an advisor to structure its Central Pubic Sector ETF. Experts say from an implementation perspective, structuring this PSU ETF will entail the creation of an Index, and then the ETF itself which will track this Index. Sanjiv Shah
MD & Co-CEO, Goldman Sachs Asset Management
"Our belief is that you will have an index which will be created like the Nifty or the BSE Sensex, an ETF will be created based on some kind of some theme or structure, where the government will basically put in the stocks that they want to divest and people will be able to understand the structure and theme behind that index. In terms of the asset managers, the ETF will work the conventional manner how it works just now." Pratibha Jain
Nishith Desai Associates
"The structure will be two fold -- one, you would have a sale from the PSU to the AMC and then the AMC would have the portfolio of companies on which the ETF would be based and then you have the sale of ETF through the brokers on the exchange from the AMC. So there are two legs to this transaction. On the second leg, there is an existing structure available through SEBI regulations and the exchange regulations which provide how ETFs will trade, who can trade in them the margin requirements etc. I think the challenge would be more on the first leg."
And that first leg would be the sale of PSU shares from the government to the AMC. Pratibha Jain
Nishith Desai Associates
"If you're looking at a listed stock and if the AMC is buying the listed stock from the PSU, it'll have to do it on the exchange. And if you do it on the block window, you have a +/- 1% restriction, if you do it through a bulk purchase on the exchange, you can do it through what we call the 1,2,3 trades but currently law there is grey- if you do the trade at a significant premium or significant discount, you're open to questions on market manipulation. So they could either create a block window without the +/- 1% restriction for trading PSU stocks or they could look at something like the OFS route without the limit on how much can you sell to one investor."
The second challenge will be selling this ETF to investors... because going by current trends, retail investors account for nearly 50 percent subscription of a ETF... and to appeal to a retail investor, pricing will become the critical factor. Pratibha Jain
Nishith Desai Associates
"You would need to figure out a mechanism by which these ETFs can be provided to the ultimate investor at a discount- whether that is through tax incentives or by providing a mechanism by which the ETF provider themselves can take these stocks at a discount from the government."
Again, here, Hong Kong may provide a workable solution. Han Ming
Partner- Capital Markets, Clifford Chance
"One of the big incentives that the government had provided was what we refer to as the loyalty bonus. This was, I think, targeted at the retail tranche. If a retail investor bought the Hong Kong Tracker in 1999 and they held it for a period of say 12 months, the government would actually issue a bonus unit at the end of that 12 month period. So you could see it as a sort of dividend payment or a bonus share issuance. That was one of the incentives offered to get the retail investor to not trade in the tracker fund but stick to a buy and hold strategy."
Distribution will be the other big challenge. By one estimate, the top 15 cities contribute 87% to the mutual fund industry. But to make PSU divestment via ETF route a success, the government will have to go beyond these. Also, given that the expense ratio for an ETF is lower than a regular mutual fund, the AMC will have little incentive for its distributor to market the PSU ETF.
Over the next few months, ICICI Securities will advise the government on the modalities of creating an Index for the PSU stocks and the ETF basket. The Finance Ministry will also select the AMC that will manage the ETF. And of course, the timing will be crucial. Some experts suggest that government should aim to launch the ETF in January-February next year when most investors plan their taxes... and that'll work only if the fund comes bundled with tax incentives. In Mumbai, with Sajeet Manghat & Payaswini Upadhyay