By Harsh Doshi
Mutual Funds have allowed retail investors to pool money and be exposed to high risk – high return scenarios.The lower the risk taken by an investor, the lower his/her expected return. Mutual Fund Investments in India, though restricted, are robust, with assets under management (AUM) growing rapidly for these funds.
What are commodity derivatives?
One asset class that retail investors are usually averse are commodities. These markets are highly complex and volatile, and investments have a high ticket price. Commodities such as agricultural products, metals and oil are traded on commodity exchanges like MCX and NCDEX. The Securities and Exchange Board of India (SEBI) has only recently proposed to allow mutual funds to invest in commodities markets, especially commodity derivatives. The returns form derivatives are from a position in an underlying asset. They protect investors from risks related to large investments. With derivatives, they can do so at only a fraction of market prices of the underlying assets, usually called a premium. SEBI has only allowed commodity futures as a derivative instrument to be traded on commodity exchanges.
This announcement was well received by all of its stakeholders. The shallow commodities market benefits as markets will finally deepen with improved participation from big institutional investors such as mutual funds which have trillions of rupees as AUM. The mutual fund managers now get another channel to hedge their bets in the markets. The retail investors will be better benefited by this move as their portfolio will now be more diversified. However, before introducing this provision, there are a few things that need to be kept in mind.
The hidden risks associated with the instruments
The commodities market broadly consist of agriculture products, metals, bullion (gold) and oil. Out of these, agricultural products are more volatile due to the nature of its output. In comparison, metal, bullion and oil are more uniform in output and hence can be better regulated. Agricultural commodity derivatives will prove all the more volatile due to bundling. Hence, it is perhaps prudent that a very small portion of the Net Asset Value (NAV) of mutual funds is fixed to invest in them. Or even more conservatively, investments in agricultural commodity derivatives in particular, may be prohibited.
There is a lack of derivatives in commodity markets, with futures as the only instruments. In order to truly deepen the market, a host of other derivatives like options and swaps need to be introduced. With Institutional Investors now entering this market, they possess both the resources and ability to effectively invest in create a market for such instruments. These complex financial products help investors spread the risks associated with the underlying investments across the market. With only futures, the full potential of opening up of markets will not be explored.
A part of a broader move toward financial development
The announcement comes in line with the most recent amendment to SEBI (Mutual Funds) Regulations, in 1996. The Seventh Schedule consisting Restrictions on Investments was relaxed as SEBI allowed Mutual Funds to now invest in Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) with certain investment ceilings. By such provisions, SEBI is acknowledging the need to deepen markets and broaden investment options for market participants. However, the need to simultaneously safeguard key institutional investors remains paramount.