A masterstroke for the commodity derivatives market
A new frontier has opened up in India’s investment landscape. Fulfilling a long-cherished wish of various stakeholders, the market watchdog, SEBI, has recently allowed mutual funds to invest in commodity derivatives. Measures such as strengthening exchanges and intermediaries through policy changes, adding entities such as mutual funds and Portfolio Management Services (PMS), permitting new products such as options and index trading are likely to increase the scope of commodity trading in the country. The move has the potential to boost the commodity market and be a game-changer. From the day that the regulation of commodity markets was brought within the scope of SEBI in the 2016 Union Budget, there has been the talk of closer integration between the commodity and equity markets. This should pave the way for retail investors to access and participate in the commodities market in a structured manner. SEBI had earlier permitted Alternate Investment Funds (AIFs) to invest in commodities and a few schemes have already accessed the market.
- Institutional participation will play an important role in adding liquidity and depth to the commodity derivatives market, leading to greater efficiency in price discovery and risk management. Moreover, this would provide the Indian investors easy access to a new asset class and cater to their diversified investment and trading needs.
- Commodities offer a better solution than many other asset classes, making this asset class ideal for retail investors. The chief features of commodities as an asset class are portfolio diversification, inflation-proofing investment and better risk-adjusted returns for the long term. Commodities are hard assets that move in different economic cycles than typical financial assets such as stocks. Thus, adding commodities to equity or multi-asset portfolios allows investors the benefit of diversification, i.e., improved risk-return ratios for their portfolios.
- Trading in commodities requires knowledge of fundamentals, as each commodity is driven by its own demand-supply dynamics. As a result, many retail investors feel inadequately equipped to break into the commodities markets. Financial entities such as mutual funds have access to high-quality research and can venture into the Indian commodity derivatives market, thereby offering multi-asset investment products with diversification benefits to a large pool of retail investors.
- For sophisticated investors, opportunities may arise in the AIF space, where they can develop commodity-trading strategies that aim at absolute returns rather than merely participating in trades. Active commodity trading uses a combination of fundamental and technical parameters to take positions in different commodities on a dynamic basis and has the ability to take long as well as short views. These products form a part of alternative allocations from an investor’s perspective.
- Commodity MFs can provide protection against equity market fluctuations. Commodities such as crude oil, silver and gold are not prone to market trends as in the case of other commodities. They are of immense value and provide good returns even when the equity market is down.
- Besides, the presence of Mutual Funds in commodity derivatives markets can make such markets more robust by providing liquidity, especially for far-month contracts. Enhanced liquidity and diverse participation groups, including hedgers, can strengthen the price-discovery mechanism of the commodities market and make risk management on exchange platforms more attractive to stakeholders by lowering the impact of the cost of trades.
How commodity derivatives will help MFs
By allocating a part of their funds to commodity derivatives, mutual funds will be able to diversify the overall risk in their portfolios. As markets turn more macro in structure, it will become difficult to reduce risk by diversifying into other stocks. In such circumstances, including commodity derivatives in a portfolio will offer diversification since commodity prices tend to run by their own logic.
The inclusion of commodity derivatives will also help MFs to participate in a raw macro fundamental directly. For example, if there is a surplus of gold production in a year, prices are likely to go down. That would curb prices of gold-based stocks and depress a portfolio value. A fund manager can use this situation by selling gold in the commodity derivatives market. Since commodity prices are more a reflection of demand-supply macros, they offer better risk hedges.
Dedicated MF and PMS schemes based on commodity derivatives may be a good option for retail investors to indirectly participate in commodity markets. At present, retail investors find commodity markets too erratic and volatile. The presence of institutional operators would mean that retail investors can participate in commodity derivatives with lower risk implications.
SEBI has permitted Category III Alternative Investment Funds to participate in exchange-traded commodity derivatives. Also, Eligible Foreign Entities (EFE) with actual exposure to Indian commodity markets, to hedge their exposures, are permitted to participate in the commodity derivatives segment of recognized stock exchanges. To further this objective, mutual funds have been permitted to participate in exchange- traded-commodity derivatives (ETCDs).
ETCDs with gold as the underlying would be considered ‘gold-related instruments for gold exchange-traded funds (gold ETFs).
SEBI has said that no mutual fund scheme should invest in physical goods, except in ‘gold’ through gold ETFs.Further, as mutual fund schemes participating in ETCDsmay hold the underlying goods in case of physical settlement of contracts, mutual funds should dispose of such goods from the books of the scheme at the earliest, not exceeding 30 days from the date of holding of the physical goods.
No mutual fund scheme should have net-short positions in ETCDs on any particular good, considering its positions in physical goods as well as in ETCDs, at any time.
Investments in commodities have dramatically increased in the last decade to the point where commodities have now become a mainstream asset class. Their increasing popularity reflects the desire of investors to benefit from the diversification into commodity investments. Globally, a number of mutual funds have started addressing this investor interest and are actively involved in commodity investment through strategies such as futures-based exchange-traded funds (ETFs), long-only or short-only strategies, actively managed commodity funds, commodity-arbitrage funds, etc.
The mutual fund industry of India, as in the global markets, has continuously been evolving. The participation of mutual funds will not only help broaden and deepen the domestic commodity market, but larger volumes will also render the markets efficient and safe. Several segments in India’s financial market saw a huge leap after institutions started participating in them in a large way, and a similar benefit can be expected in the commodity markets when mutual funds start offering schemes with commodity derivatives.
Commodity exchanges and well-informed clients are very important for a strong commodity eco-system. Exchanges provide transparent price discovery and efficient trading platforms for clients to hedge price uncertainty. A fair value for commodities can be determined through the participation of a large number of stakeholders in the value chain.
To widen and deepen the commodity market, systematic development of markets through continuous innovation, education, research and spreading of awareness among various stakeholders indispensable. Also, product innovation in line with changing market dynamics and emerging challenges would make the platform more vibrant.
To summarise, commodities are a credible asset class that offers investors a great opportunity. Nevertheless, their behaviour and complexity mean that investors need to watch their performances closely and regularly. One thing is for sure- commodity derivative trading in India is set for rapid expansion after SEBI’s recent moves.
Author: Mr.Jigar Trivedi Commodity Research (Investment Services), 4th December 2019