“Derivatives are financial weapons of mass destruction.”—Warren Buffett

Securities and Exchange Board Of India (SEBI) has ignored this dire warning given by the legendary investor of all times.

The capital market regulator seems to be self-assured in matters wherein it should rather be circumspect of its actions.

It has decided to allow mutual fund houses to invest in commodity derivatives.

Reason?

The volume in the commodity markets is low at present. So to improve the participation, SEBI has been encouraging institutional investors to take exposure to commodity derivatives.

Enlightening more on the subject, the SEBI chief Mr U.K. Sinha said, "Mutual funds' participation in commodities derivatives would be the first one to happen among institutional investors." 

In investing, suitability is the key. Unless the product is suitable to the investor, it doesn’t matter, how well-structured and transparent it is, seldom it will serve the purpose.

Let’s understand, whom the commodity derivatives are meant for.

Derivatives products are the contracts on underlying assets. Equity derivatives are the contracts on equity shares, while commodity derivatives are the contracts on commodities. Needless to say, the price movement of the underlying asset affects the value of derivatives contract.

Therefore, derivatives help investors hedge their positions. For example, a company making car doors might be affected by the price fluctuations in aluminium. Falling prices may boost its profits, but rising prices may erode margins. So if the company expects the commodity prices to move up significantly in the short run, it will buy aluminium at current prices.  

But what if prices fall? It would suffer notional losses because if it waited until then, it would have bought the metal at a much lower price.

The company can’t halt the production until then.

In such a scenario the company may take the delivery of the metal at the current market price and sell the metal in the future market. Obviously, one of the positions will make losses, but the other position will make profits; thereby reducing the overall impact on the company.

Now the question is, do mutual funds invest directly in commodities or take the delivery of any of them?

You may not have heard of a mutual fund scheme investing in Nickel, Copper or Cardamom.

Mutual funds are not meant for that.

Mutual fund schemes channelise household savings into equity and debt markets. But, it’s noteworthy that, they do take the delivery of bonds and equity shares. Thus, their investing in equity and interest rate derivatives is still understandable.

 But commodities?

Looks a weird idea.

No harm until now, as mutual fund houses haven’t made any significant comment on the proposed move by SEBI. Commodity prices are extremely volatile, and contracts are often illiquid to support large volume trades. If any deal of mutual funds fails, it will be difficult for them to recoup losses.

It remains to be seen how mutual funds approach commodity derivatives once they get the clearance from SEBI.

The only unanswered question is: Why experiment with investors’ hard-earned money?

If the test fails and mutual fund schemes lose money, there would be a backlash.  

Who will be accountable for that? Investors, after all, they should “read the scheme information documents carefully before investing.”

It’s possible that mutual fund houses may launch New Fund Offers (NFOs) targeting the investments in commodity derivatives. But remember one thing, always…

You don’t need any such product if your motive is just to meet your long-term financial goals. To know about which mutual funds you should invest in, do subscribe to the unbiased mutual fund research services offered by PersonalFN.

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