SEBI has allowed fund houses to participate in commodity derivative markets through exchange traded commodity derivatives (ETCDs).
Unlike an ETF structure where fund houses are required to maintain physical reserve of commodity with the custodian to offer units (gold ETFs for instance), mutual funds can now take positions in commodity markets through a futures contract. Simply put, mutual funds can invest in commodity markets through gold, silver, zinc and copper futures.
According to investors’ website Investopedia, “An exchange traded derivative is a financial instrument that trades on a regulated exchange and whose value is based on the value of another asset. Simply put, these are derivatives that are traded in a regulated fashion. Exchange traded derivatives have become increasingly popular because of the advantages they have over over-the-counter (OTC) derivatives, such as standardization, liquidity and elimination of default risk. Futures and options are two of the most popular exchange traded derivatives. These derivatives can be used to hedge exposure or speculate on a wide range of financial assets like commodities, equities, currencies and even interest rates.”
However, fund houses will have to take a long-term view as short positions are not allowed. For instance, if a fund manager has a bullish view on the long-term prospects of silver, the fund house can participate in it through silver futures by paying a premium. However, if a fund manager has a bearish view, he cannot participate in such contracts.
SEBI’s decision to permit mutual fund participation in the segment comes on the back of the regulator’s desire to deepen the commodity derivatives market in India. In the last two years, SEBI has permitted participation of Category III Alternative Investment Funds and allowed Eligible Foreign Entities to invest in them.
Mutual funds will be able to invest in ETCDs, subject to the following rules:
- Fund houses will have to appoint a dedicated fund manager and custodian
- Lay down a formal investment policy and valuation policy
- Mutual funds can take exposure to ETCDs in their hybrid schemes and gold ETFs
- They can invest in any Indian ETCD except those which are classified as ‘Sensitive Commodities’. Sensitive commodities are agricultural commodities prone to frequent government or external interventions in terms of trade barrier or import/export restrictions. Or these are agricultural commodities that have seen frequent price manipulation in the last five years.
- No MF schemes shall invest in physical goods except in ‘gold’ through Gold ETFs. Further, as mutual fund schemes participating in ETCDs may hold the underlying goods in case of physical settlement of contracts, in that case mutual funds shall dispose of such goods from the books of the scheme, at the earliest, not exceeding 30 days from the date of holding of the physical goods
- Mutual funds cannot run net short positions in ETCDs to mitigate risk
- If the fund house wishes add ETCD exposure in an existing scheme, it will be treated as fundamental attribute change and investors will be given the option to exit the scheme
- Fund houses will benchmark schemes with ETCD exposure against appropriate benchmark
- Foreign Portfolio Investors (FPIs) will not be able to invest in schemes having ETCD exposure
Investment limits
- ETCD Investment in a single commodity cannot be more than 10% of the scheme’s assets. However, the limit will not be applicable for Gold ETFs investing in gold ETCDs. Gold ETFs can have maximum cumulative exposure of 50% to gold related instruments that is GDS, GMS and ETCD. Also, individual exposure to GDS and GMS cannot exceed 20% while the remaining portion can be utilised by ETCD
- Multi-asset allocation schemes can invest up to 30% of their assets in ETCDs
- Other hybrid schemes can have maximum 10% exposure in commodity derivatives
- The cumulative gross exposure through equity, debt and derivative positions (including commodity derivatives) shall not exceed 100% of net asset value of the scheme. Simply put, leverage is not allowed
Disclosures
- Schemes investing in ETCDs will have to update their NAV daily on their website by 9 am the following calendar day
- The ETCD investment will be shown in the monthly and half yearly portfolio
- The fund house level total exposure to ETCDs shall be disclosed as a line item in the monthly cumulative report (MCR) submitted by mutual funds
Taxation
Though there is no mention on taxation front, experts believe that ETCDs will be considered as non-equity or debt instruments for taxation purpose. Hybrid schemes will have to reduce exposure to debt instruments to invest in ETCDs
Impact on investors
Experts believe that the move would help fund houses to offer diversified portfolio to investors. However, it will be difficult to ascertain liquidity and valuation of such securities, they added.
