Is it viable to invest in PSU ETF?

The much-awaited exchange-traded fund (ETF) that will invest in top central government-owned companies has finally opened for subscription. Managed by Goldman Sachs Asset Management Company, a specialist in ETFs, the fund will invest in 10 Central Public Sector Enterprises or CPSEs in India. The ETF was offered at a 5% discount during the new fund offer (NFO) period from 19 March to 21 March 2014.

Retail investors holding units of the ETF for one year from the NFO allotment date will get one loyalty unit for each 15 units held. The fund will reopen for subscription from 11 April 2014. During the NFO period, the ETF will collect a maximum of Rs 3,000 crore. The ETF will comprise companies such as ONGC, Coal India, GAIL, Oil India and Indian Oil Corporation.

It will be benchmarked to the CPSE index. The stocks in the CPSE index are chosen on the basis of three broad parameters. First, the company should have 55% or more government holding and should be part of the list of CPSEs published by the Department of Public Enterprises. Second, it should have at least 4% dividend yield and a record of paying dividends for the last seven years.

Third, it should have a free-float market cap of at least Rs 1,000 crore. Should you invest? On the valuation front, the CPSE index is trading at a price-to-earning multiple of 10.5 times as against Nifty's 18 times. So, it makes sense to invest a part of the funds in the ETF. However, a more compelling reason is the dividendpaying record of CPSEs. One of the criteria for inclusion of a CPSE in the fund is that it should have been paying dividends for at least seven years. Therefore, the fund will likely receive steady cash flow from its holdings in the form of dividends.

On an average, the companies that are part of the CPSE index had a dividend yield of 3.5% compared with Nifty's 1.44% calculated on the basis of March 18 prices. ETFs by their nature are low-cost as they are passively managed. The maximum annual fee under CPSE ETF will be 0.49% of the total assets under management. Actively managed funds, where a fund manager, based on his research, picks stocks and decides their weight in the portfolio, charge as much as 2.7% annually.

Additionally, first-time equity investors can also claim income tax deduction up to Rs 25,000 a year as the ETF is eligible under the Rajiv Gandhi Equity Savings Scheme. Notwithstanding the positives, the CPSE ETF, by virtue of having a high concentration portfolio, remains a risky fund to invest.

The top three holdings- ONGC, GAIL and Coal India-account for more than 60% of the portfolio. The entire portfolio is heavily tilted towards sectors whose performance is linked to government policies and economic cycles. Moreover, public sector companies depend upon their political bosses, which adds to uncertainty about their performance. Melvin Joseph, founder, Finvin Financial Planners, says, "The combination of cyclical and PSU companies makes it a very risky fund to invest in." Vishal Dhawan, founder, Plan Ahead Wealth Advisors, says, "At this point, with general elections coming up, we need to remember that these PSUs have the government as the largest shareholder. Therefore, we need to wait to see how the new government formation shapes up, and the resultant ability of PSUs to run their businesses and their financial decisions independently. Hence, we are not recommending investing in the PSU ETF at this point."