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India ETN Tripped Up by Local Regulators

The iPath MSCI India Index ETN can't issue new shares, and prices are diverging from net asset value.

The iPath MSCI India Index ETN (INP) was created as a liquid vehicle for investing in the Indian stock market.

As one of the few exchange-traded products that offers a pure play on one of the world's fastest-growing economies, it has been extremely popular, with about $1.11 billion in assets under management and average daily volume of 800,000 shares.

But since INP ran afoul of the local regulatory authority last fall, it hasn't been acting like itself.

INP is an exchange-traded note, a kind of senior, unsecured debt issued by


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. Like exchange-traded funds, ETNs trade throughout the day on an exchange, making them easy to buy and sell.

And like ETFs, ETNs can issue new shares, or dissolve existing ones, as demand rises and falls. This helps keep share prices in line with the value of their benchmarks.

Until last October, that was the case with INP; it traded closely in line with its benchmark, the MSCI India Total Return Index. But then the Securities and Exchange Board of India decided it to let a little air out of the local stock market.

India's market was one of the world's best performers last year. The Bombay Stock Exchange's benchmark index the Sensex rose 47% last year, while the ETN's benchmark, the MSCI India Total Return Index surged 73%. The SEBI felt a huge influx of foreign money was pushing the market into bubble territory. So, on Oct. 26, it instituted a new regulation requiring all foreign investors to register with it.

The SEBI also ruled that an investment instrument called a participatory note -- a category of investments that includes ETNs -- could no longer be based on derivatives by foreign institutional investors.

Unlike ETFs or other kinds of funds, ETNs don't hold stocks or other securities. Essentially, they are backed by the issuer's promise to match the return of an index, minus expenses.

That meant INP could no longer issue new shares. And now that the supply is fixed, the share price has been moving out of line with net asset value -- sometimes wildly out of line. For example, on Friday, INP's shares closed at $87.20, or a 3% premium to the daily indicative value of $84.81. This morning, the price tumbled down 16% to $72.93, but recovered to be down 5.5% at $82.50 by midday, a 2.7% discount to the indicative value of the underlying assets.

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Shares have traded at a premium of as high as 25% over the past several months.

Effectively, the ETN is trading like a closed-end fund.

This volatility has reduced INP's appeal, since investors who buy at a premium risk having to leave some money on the table if they need to sell and the share price has fallen to a discount.

(Of course, investors who buy the ETN when it's trading at a discount could really clean up if they wait until the shares move up to a premium to sell.)

"The Indian regulators are throwing sand into the gears for investing in India," says Jim Kelly, chief executive of Kelly Capital Management of Philadelphia. Kelly is one of the first asset managers to make portfolios out of ETFs.

"You want to buy an ETN because it can continue to issue shares and it should always trade in some reasonable range of less than 1% up or down from the NAV," adds David Fry, founder and publisher of


, an online investment newsletter.

He says Barclay's "hasn't done a very good job of communicating this change to the market."

Barclays did issue a press release when it stopped issuing new shares, and it lists the share price and indicative value of the NAV on the iPath's Web site each day.

Ironically, the

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India Fund, a true closed-end fund that tracks this market, was trading at a 10.6% discount as of Friday's close. That suggests that INP is still a more popular investment vehicle.