MFs' entry in commodity derivatives to set stage for more commodity ETFs

At present only gold ETFs deal in physical gold. All other ETFs hold stocks or indices as underlying assets
As the route opens up for mutual funds to participate in commodity derivatives, the stage will be set for extending the process to commodity exchange-traded funds (ETFs).

The Multi-Commodity Exchange (MCX) has proposed to the Securities and Exchange Board of India (Sebi) to allow exchange-traded funds in commodity derivatives. Sebi is finalising changes to Mutual Funds Regulations, allowing them formally in commodity derivatives. 

ETFs are run by mutual fund management companies and hence while allowing MFs, the regulator should also allow ETFs. At present, only gold ETFs deal in physical gold. Other ETFs have stocks or indices as underlying assets.

The MCX has proposed that when MFs are allowed in commodity derivatives, ETFs run by the same asset management companies should automatically be allowed in commodities and offer such funds in many other commodities. 

In the past ETFs for silver and crude oil were also proposed but not permitted by the regulators. 

A fortnight ago the Sebi board decided to amend the Custodian of Securities Regulations to allow custodial services in goods underlying commodity derivative contracts in order to enable the participation of institutional investors in the commodity derivatives market. 

With this change, a way has been opened for Alternative Investment Funds (AIF) or hedge funds and mutual funds to enter commodity derivatives. While AIF regulations have been amended earlier, the regulator’s next board meeting is expected to clear changes in regulations for mutual funds.

The proposal of the MCX goes like this: A commodity ETF sells units to investors. As in the case of gold, it has to simultaneously buy physical gold of an equivalent amount and keep that in the vault. 

If other commodity ETFs come in, even they will have to buy physical commodities as an underlying. This is provided for ensuring retail investors invest in commodities through ETFs.

The MCX said instead of physical assets, they should be allowed to buy commodity futures. Since investments in ETFs are usually for longer terms, ETFs have to keep rolling over futures with each contract expiring. 

A senior MCX official said the annual cost of a roll-over on the exchange was around 6 per cent and the capital required for buying is 5-6 per cent of the exposure.

ETFs, after buying futures, can invest the rest of the amount in safe securities. The returns are around 7 per cent. This will leave the fund with some distributable surplus to offset the roll-over cost. Currently investors have to bear the burden of management fees on gold ETF investment. 

However, gold ETFs were allowed in 2007 by a special notification issued by the finance ministry. The reason was such funds were allowed to invest through stock exchanges and not on commodities exchanges. Hence a legal clarity for stock exchange investors to deal with commodity was required.

However, now commodity derivatives and equities are under Sebi and hence ETFs in commodities can be expected. The MCX official quoted earlier said, “ETFs should be allowed to buy futures instead of physical commodities and the notification that allowed ETFs in gold shall be rescinded or amended as it is not relevant after a powerful regulator like Sebi started regulating commodities.” 

This will pave the way for gold ETFs to buy only gold derivatives and not physical gold as they are required at present.

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