Mutual Funds and Portfolio Managers in Commodity Derivatives Segment

Why in news?

SEBI has put forth proposals to allow mutual funds and portfolio managers to invest in commodity derivatives segment.

What are Commodity Derivatives?

• Derivatives - Derivative is a contract between two or more parties.
• Its value is determined by the underlying asset.
• The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
• Commodity Derivatives - It's a derivative contract with a commodity as the underlying asset.
• Producers who want to manage the risk of future price uncertainty for their commodities enter into commodity derivatives.
• In India, like a stock market NSE provides a platform to trade in different shares, the Multi Commodity Exchange (MCX) and National commodity derivative Exchange (NCDEX) facilitate for the commodities.
• MCX is known for the trading of Bullions metals (Gold, Silver, etc), Base Metals (Zinc, Aluminium, etc) and Energy (Crude Oil and Natural Gas).
• The NCDEX is known for trading in Derivative contract of agricultural produces.

What are Mutual Funds and Portfolio Managers?

• Mutual Fund (MF) is an investment vehicle made up of a pool of moneys collected from public investors.
• The pooled money is used to buy other securities by professional money managers.
• They give small or individual investors access to professionally managed portfolios of equities, bonds and other securities.
• Portfolio Manager (PM) is a professional person or a group of people, usually experienced investors responsible for making investment decisions on behalf of individuals or institutions.
• The main difference between MFs and PMs is that in Mutual Funds, the investors’ money is pooled and collectively invested, which is not the case with PMs.

What is SEBI's recent proposal?

• As of now, only gold is a permissible commodity for institutional investors, and is allowed through exchange-traded funds (ETFs).
• SEBI had earlier attempted to increase the institutional participation in the commodity segment.
• E.g. It recently allowed category -III Alternative Investment Funds (AIFs) to participate in the commodity derivatives market.
• In line with this, allowing mutual funds and portfolio managers in the commodity derivatives segment aims at broadbasing the commodity derivative segment.
• SEBI's Commodity Derivatives Advisory Committee (CDAC) has also suggested opening up the market to both domestic and foreign institutional investors in a phased manner.

What are the benefits?

• The Indian commodity derivatives market was lacking the desired liquidity and depth as it was running without any institutional participation.
• The current move fills this gap and hence brings in efficient price discovery and price risk management.
• There is also a huge surge in Mutual Funds in recent periods, indicative of widening base of investors.
• So allowing MFs and PMs in the commodities segment comes as an additional or alternative asset class for diversification.
• It is also in line with the series of liberalization measures in the past couple of years for investors to increase participation in domestic institutions.

What are the cautionary steps to be taken?

• Risks - SEBI has said that the overall risk adjusted return of the portfolio might improve.
• Nevertheless, adequate checks and balances will have to be put in place before implementation.
• Investors' Money - Commodities prices tend to fluctuate violently.
• Hence, Mutual funds, being custodians of investors’ money, will need to be extra cautious while investing in them.
• SEBI has to ensure that scams like the one involving the National Spot Exchange Limited (NSEL) do not recur.
• Level Paying - Facilitating greater participation by retail investors and small commodity producers in this market is essential.
• Regulation – MFs and SEBI need to appreciate that commodity derivatives and shares are totally dissimilar objects.
• They thus demand different expertise and skills for trading, as also for monitoring and effective regulation.

Quick Facts

Alternative Investment Funds

• An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds and cash.
• Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.
• Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of the complex natures and limited regulations of the investments.

Source: Business Standard