Some fund houses have been exploring the possibility of commodity derivative trading for the past two years
The proposed entry of mutual funds
and portfolio management service (PMS) providers in the commodity derivatives segment is set to provide a big boost to the derivative market through increased hedging, especially for producers, besides improving depth and liquidity in far-month contracts as well.
Fund houses, PMS managers and experts are optimistic about the opportunities to be thrown open by the proposed move. However, they concede that there are several milestones to be crossed and challenges to be met before the full potential of this market is realised.
The market regulator, Securities and Exchange Board of India (Sebi), is expected to soon notify the rules for the entry of two categories of market participants — mutual funds
and PMS — in the commodity derivatives market. Several PMS firms, brokerages running them, and at least five of the top 10 mutual funds, along with a few mid-sized funds, are looking at the schemes with underlying commodity assets. The main reason is that mutual funds, traditionally long-only investors, will look to launch investment products to give a portfolio diversification opportunity to investors.
The chief executive of one of the top mutual fund asset management companies said: “We are awaiting regulations to clarify the commodities in which we can enter, and whether we have to launch independent schemes for commodities or we can launch hybrid schemes as well.”
According to a senior executive at another big AMC, it would be better if they are initially allowed to convert their existing schemes into hybrid ones with the option to partly invest some money in commodities. That is because there is not enough liquidity and depth in the market for investing large sums.
Sebi allowed alternative investment funds or hedge funds in commodities, but that move proved almost a non-starter, given the exposure limits and lack of permission to apply multiple trading strategies.
These executives are not willing to come on record till new regulations are out and they prepare the scheme for launch. Currently, they are not sure even about the focus of the schemes they can launch.
Some fund houses have been exploring the possibility of commodity derivative trading for the past two years; a few brokerages had even started advising their clients to take positions synchronising between commodity derivatives and equities. One of them said their investors made much higher gains with such a blending.
For example, when commodity analysts are bullish on copper, the share prices of copper smelters like Hindalco move up. So, for short-term traders or investors of equities, trends in commodities provide important tips. Such results of blending investment ideas have triggered optimism among portfolio managers. Industry observer tracking brokerages say that over 100 brokerages with PMS are preparing to launch schemes for commodities.
One senior official of an equity exchange said: “We are discussing this issue with fund houses but more concrete discussions will be possible after details of documentation and focus of the schemes are clarified.” After that, based on MFs’ response, “we will also consider launching special schemes for them”, the official added.
There are other challenges, too. For example, fund houses have to deal through custodians, who are still sceptical about taking delivery of commodities which they have not dealt with in the past. One large custodian has applied to the regulator seeking approval to deal in commodity derivatives. An official with the knowledge of developments at the regulatory front said: “Sebi is likely to allow institutions to deal only in non-sensitive agri commodities, along with non-agri commodities, but MFs would stay away from agri-complex as a whole due to the sensitive nature and problems in holding agri-commodities for long, as many commodities eventually become non-deliverable on exchange platforms because of quality concerns.”
An erosion in the quality or value of a commodity, if it remains in warehouse for too long, is a major cause for concern.
However, Mrugank Paranjape, managing director and chief executive of MCX, the largest commodity derivatives exchange, said: “Institutional investors will help commodity markets
in two very specific ways — first, they will help retail investors get an informed option for investing in this market; and second, their own need for long-term investment will help build liquidity in far-month contracts. To stick to their investment commitment and not entering the speculation arena, funds will park money required to take the delivery in an escrow account after arranging for margin till they take delivery or exit.”
There is also the issue of liquidity in long-term contracts or lack of longer-duration contracts. MFs are long-only investors looking for gains from rising prices. In commodities, they prefer to stay invested for a year, if not more. That type of liquidity in long-term contracts is yet to come. One mid-sized fund’s product head said, to begin with, he would prefer to do arbitrage, including through trading in spread contracts, or buying one contract and selling in another contract of the same commodity. This could provide liquidity as well.
Since MFs prefer to stay invested for a year or more, carrying forward positions, like financiers and traders do, would be very costly if they have to stay in the contract for a year. The chief financial officer of a large fund said: “We will prefer to take deliveries and retain stock with warehouses. The cost on account of goods and services tax (GST) is part of the business. Even gold exchange-traded funds pay GST as they take deliveries.”
Another positive which has worked in the argument favouring institutional players in the segment is that large commodity producers like metal companies and oil refineries do not come forward for hedging their risk in the Indian market. The reason is lack of liquidity, especially in longer-duration contracts. If there are buyers, these producers can sell their future produce in longer-term contracts to hedge the risk; that meets the requirement of both buyers and sellers.
However, there is some scepticism over whether these companies and funds will come and do trading. But that is something only time will tell. Industry observers say “this does not seem to be happening at least in 2019”.