Should Mutual Funds Risk Your Money With Commodity Derivatives?   Mar 05, 2019


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India is one of the biggest consumers and producers of various commodities. Thus, fluctuations in commodity prices can vastly affect the performance of Indian economy.

For instance, crude oil.

Have you considered buying a derivatives contract of crude oil on a commodity exchange?

Many of you probably may think it's too risky, and/or perhaps could lack the necessary acumen to deal with commodity derivatives.

Can mutual funds help you invest in commodity derivatives?

Up until now, they couldn't.

Recently, however, the Securities and Exchange Board of India (SEBI) allowed mutual fund houses and Portfolio Management Services (PMSes) to invest in commodity derivatives. It's a welcome step to encourage institutional participation in a commodities derivatives market.

With this move, the capital market regulator has attempted to create a win-win situation for all- the investors, exchanges, commodities market, and the overall economy.

Importance of encouraging the institutional participation in commodities...

You might be aware that India meets nearly 80% of our crude oil demand through imports. When crude oil prices rise significantly, not only does it affect the nation's balance sheet, it consequently affects your personal finances too.

Moreover, commodity prices affect the performance of stocks in your portfolio as well as your mutual fund schemes, depending on whether the companies are producers or consumers of the commodity.

Earlier, mutual funds and individual investors alike had no defence against commodity price fluctuations. With the capital market regulator allowing investments in commodity derivatives, this lacuna in the risk management would be bridged.

Hedging the exposure of commodity stocks in the portfolio would now become possible for mutual funds.

Mr S K Mohanty, a whole-time member of SEBI, has called this move a 'game changer.'

He remained confident about the positives of allowing mutual funds and PMSes to invest in commodity derivatives. At a FICCI event he hinted at further possibilities: "We will soon allow portfolio management services and mutual funds in commodity derivatives. This is going to open the gateway for several other products like ETFs among others."

Mr Mrugank Paranjape, MD and CEO of India's largest commodity exchange, Multi Commodity Exchange (MCX) also made optimistic remarks about the development. "Institutional participation will play an important role in adding liquidity and depth to the commodity derivatives market, leading to enhanced efficiency in price discovery and risk management. Moreover, this will provide the Indian investors easy access to a new asset class and cater to their diversified investment and trading needs", he said.

Why has the participation in commodities market been low so far?

Six years ago, the National Commodity and Derivatives Exchange (NCDEX) reported a scam. Following which, volumes on commodity exchanges fell significantly. Moreover, the imposition of commodity transaction tax (CTT) on non-agriculture commodities had a negative impact the turnover on commodity exchanges.

Tightening of the regulatory framework

To protect investors' interest, in the recent past the capital market regulator introduced a series of changes to the regulatory framework for commodity derivatives.

The regulator released a compilation of circulars from time to time for commodity derivatives market titled Master circular on Commodity Derivative Market dated September 18, 2018.

The master circular reiterated SEBI's guidelines on various aspects such as governance and administration of exchanges and clearing corporation, trading and warehousing norms, risk management, contract approval and modification, delivery and settlement, investor protection, among others...

Moreover in the circular issued on November 15, 2018, the capital market regulator also directed listed companies to include detailed disclosures on risk exposures on account of the volatility in commodity prices and measures adopted thereof.

SEBI recently released a consultation paper titled: "Consultation paper on design of commodity indices and product design for futures on commodity indices" inviting public comments. The regulator is expected to grant permission to launch commodity indices.

The regulator has taken many more initiatives to create a vibrant market for commodity derivatives.

This is how the new norms will affect mutual fund investors...

While it's clear that mutual funds will invest in commodity derivatives, clarity is required on whether they will launch new products right away or initially be content with making modifications in the existing product mandates/objectives.

For now, you as a mutual fund investor need not take any action. However, you need to track developments closely.

It seems the capital market regulator has allowed mutual funds to invest in commodity derivatives for better hedging. If mutual fund houses invest in commodity derivatives for earning trading gains, they might end up exposing investors to unwarranted risk/s.

On the contrary, if they do decide to tap arbitrage opportunities, it could benefit investors.

Therefore, until mutual fund houses clarify their future course of action, based on the recent regulatory developments, avoid all speculation on the advantages and disadvantages of mutual funds investing in commodity derivatives.

Remember to consider your financial goals, time horizon, and risk appetite before investing in mutual funds. When selecting a mutual fund scheme for your portfolio, analyse all the available options on various qualitative and qualitative parameters.

[Read: Looking for the Best Large & Midcap Funds of 2019? Find Out Here ]

PS: Are you concerned about your preparedness to cope with a changing regulatory landscape and product innovation?

Maybe you aren't sure about which mutual funds will help you create long-term wealth.

If these worries often weigh you down and you need expert advice, here's an excellent opportunity for you.


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Author: PersonalFN Content & Research Team



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