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How Mutual Funds can add value in commodity derivatives.

02 Mar 2023

From the time the regulation of commodity markets was brought under the ambit of SEBI in the 2016 Union Budget, there have been talks of a closer integration between the commodity markets and the equity markets. Shortly after that, Alternate Investments Funds (AIFs) were permitted into commodity derivatives SEBI now has a plan to allow Indian mutual funds to participate in the Indian commodity markets. Currently, Indian mutual funds are permitted to invest in equity, futures, options and debt (both short term and long term). Once the proposal to permit MFs into commodity derivatives is cleared, they will have one more asset class to invest in.

How will the MF exposure to commodity derivatives be structured?
Frankly, the whole proposal is still at a conceptual stage and SEBI has also sought feedback on specifics of the proposal. In terms of structure, SEBI may allow commodity arbitrage funds or dedicated commodity futures funds. Alternatively, mutual funds may also be permitted to allocate a certain portion of their existing scheme corpus into commodity derivatives. There are also likely to be limits on exposure to each commodity with individual commodity exposure not exceeding 10% of the overall exposure. Then there could also be overall exposure limits in INR terms like there is a limit on overall institutional exposure in F&O in equity futures and options. While, the proposal is approved in principle, the finer details are yet to be worked out.

How commodity derivatives will help Mutual Funds?

By allocating a part of their funds into commodity derivatives, the mutual funds will be able to diversify their overall risk in their portfolio. As markets turn more macro in their structure, it will become difficult to reduce risk by diversifying into other stocks. Under such circumstances, including commodity derivatives in the portfolio will offer a better diversification since commodity prices tend to have their own logic.

The inclusion of commodity derivatives will also help the mutual fund to participate directly in raw macro triggers. For example, if there is a surplus of cotton production during a year, then the prices are likely to go down. That will impact the price of cotton based stocks and depress the portfolio value if they are part of the portfolio. The fund manager can pre-empt this situation by selling futures on Cotton in the commodity segment. Since commodity prices offer a more direct reflection of demand-supply macros, they offer a better risk hedge.

While the equity market in India is fairly matured, the commodity market is still in its nascent stages. India does not have the extent of quality research into commodities as it has into equities. That means greater pricing inefficiency in commodities and better opportunities to make profits. With their strong institutional networks and strong access to quality research, mutual funds should be in a better position to leverage on these advantages and earn than added alpha in commodities. Both the funds and the fund holders will be the beneficiaries in the process.

Dedicated MF schemes and PMS schemes based on commodity derivatives may be a good option for retail investors to indirectly participate in the commodity markets. Currently, retail investors find the commodity markets too erratic and volatile for their liking. The presence of institutional players will mean that retail investors can participate in these commodity derivatives with lower risk implications. That will not only expand the product and AUM offering for the mutual funds, but also give a new avenue for retail investors who are seriously looking at new asset classes for alpha.

How the commodity markets will benefit from MF participation..
From the perspective of commodity markets there will be 2 key benefits from the participation of mutual funds. Firstly, institutional participation will help broaden and deepen the markets. Mutual funds will be able to participate in the commodity markets with bigger volume of funds helping to make the market safer and more efficient. We have seen in the case of equity F&O markets that the real boost to the equity options segment came only after the institutions began participating in a big way. Secondly, allowing MFs into commodity derivatives will pave the way for allowing FIIs banks and other institutions into commodity derivatives. Currently, banks are not permitted as it would tantamount to using public funds to finance trading in commodities. Similarly, FIIs have not shown too much interest in commodity derivatives due to the abstract nature of the markets. If MFs take the lead we could see other institutional players also follow suit.

Key risks in commodity derivatives that MFs must be conscious of..
Of course, the commodity market is still evolving and the participation of mutual funds will add to the breadth and the depth of the markets. However, there are 3 distinct risks that mutual funds must be cognizant of. Firstly, the spot markets and futures market in commodities are discrete. While SEBI regulates commodity futures, it is the individual states that regulate the commodity spot markets. That is a big challenge for commodity arbitrage. Secondly, governments tend to be quite sensitive to volatility in prices of critical commodities. We have seen that in the past and that is a risk that continues in commodity markets. Lastly, mutual funds may not have the expertise to actually assess the risk of commodity exposures and that is still an open area.

Nevertheless, it must be said that permitting mutual funds into commodity derivatives is a step in the right direction. We will have to await the fine print now!

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