Tread cautiously

MFs' entry into commodity derivatives is a risky bet

The proposal by the Securities and Exchange Board of India (Sebi) to allow mutual funds and portfolio managers to invest in commodity derivatives needs to be weighed cautiously before a final decision is taken. This move is part of Sebi’s efforts to open up the commodity derivatives market to institutional participation, domestic and international, in a phased manner, as suggested by the regulator’s commodity derivatives advisory committee. Gold is, at present, the only commodity in which institutional investment has been allowed through exchange-traded funds. Portfolio management service firms were earlier allowed to trade in commodity derivatives, but they were stopped by the erstwhile regulator, the Forward Markets Commission, in a controversial move.

There are, admittedly, some advantages to the move, the main being induction of liquidity and greater market depth to ensure efficient price discovery and risk management. These entities can be expected to indulge in research and market intelligence-based trading, which is lacking now. For mutual funds, commodity derivatives can serve as a new asset class to diversify their portfolios. As pointed out by Sebi in a note for stakeholders, adding commodities in portfolios can typically increase some risks for mutual funds, but the overall risk-adjusted returns may be higher. Besides, it can help them to act as conduits to commodities markets for retail investors.

But it is also true that the involvement of mutual funds or other financial institutions in the innately hazardous commodities business may well entail some unforeseeable consequences. Since the volumes of many goods traded on futures platforms are thin, players with deep pockets and a big risk appetite can potentially influence the market, including spot prices. Mutual funds and Sebi need to appreciate that commodity derivatives and shares are totally dissimilar objects, and need different expertise and skills for trading, as also for monitoring and effective regulation. Each commodity has its own market dynamics, depending on a number of factors such as local and international production and demand, available inventories, import and export tariffs, price trends, and government policies. Mutual funds, being custodians of investors’ money, will need to be extra cautious while investing in commodities whose prices tend to fluctuate violently. The regulator, on its part, will have to ensure that scams like the one involving the National Spot Exchange Limited (NSEL) do not recur.

To counterbalance the influence of large, cash-rich players, greater participation by retail investors and small commodity producers in this market is essential. The nearly four-decade-old ban on futures trading was lifted in 2002-03 chiefly for price discovery and risk management of agricultural goods for the benefit of farmers. However, this purpose is not being served although the emergence of producers’ organisations has provided an opportunity for farmers to trade on commodity derivative bourses through them. Merely 50 of over 2,000 such bodies are linked to these exchanges. This apart, Sebi will do well to expedite launching of options trading in commodity derivatives. That will help woo small operators by giving them the right, but without the obligation, to honour contracts depending on prices prevailing at the time of maturity. Retail investors will find this to be the best hedging tool.