Is allowing mutual funds and AIFs to invest in commodities an opportunity or hype?

Another thing that comes in the way of passive commodity products is lack of understanding about commodity markets by investors. (iStock)

A new frontier has opened in India’s investment landscape. The Securities and Exchange Board of India (Sebi) has permitted mutual funds to invest in commodities and offer schemes linked to the same. This should pave the way for retail investors to get access to and participate in the commodities market in a structured manner. Sebi had earlier permitted alternate investment funds (AIFs) to invest in commodities and we have already seen a few schemes accessing the market.

So what does this change mean for the investors—is it all hype or will commodity funds make a meaningful difference to their portfolios? Let’s dive deeper to understand what may happen.

First things first, it is important to note that commodity markets have had a pretty rough ride in recent years. We have seen a lot of volatility even as the market has struggled to generate returns. In fact, the Thomson Reuters MCX India Commodities Index (a composite index representing the most significant and liquid commodities in India) is broadly at the same level today as it was in 2011—that is nil return for the last eight years.

So does that mean that commodity investing does not work? Well it is not so straightforward. Commodities represent hard assets that move in different economic cycles compared to typical financial assets such as stocks or bonds. Thus, adding commodity to equity or multi-asset portfolios allows investors to get the benefit of diversification—i.e. an improvement in the risk-return characteristics of the portfolio. For example, between 2007 and 2019, a 90% equity and 10% commodity portfolio delivered a similar return as a pure equity portfolio, according to data from Bloomberg, while having much lower volatility.

So commodity allocations need to be seen in this light. While absolute returns offered by commodities may be lower, they strengthen the portfolio through their diversification properties.

This property of commodities will reflect in the kind of products that the mutual fund industry is likely to offer investors (especially retail investors) in the initial phase of the market opening up. We are more likely to see commodities being included in asset allocation funds even as we don’t expect to see a lot of dedicated commodity funds.

However, for sophisticated investors, there may be opportunities in the AIF space where they can participate in commodity trading strategies that target absolute returns rather than having a simple participation objective. Active commodity trading uses a combination of fundamental and technical parameters to take position in different commodities on a dynamic basis, and has the ability to take a long as well as a short view. These products form a part of alternative allocations from an investor’s perspective.

Globally, we have also seen a number of passive commodity exchange-traded funds (ETFs) being launched, but we believe that those will need to be carefully thought through in India and may struggle to catch investor interest. The reasons are multiple—commodity markets are narrow, with trading lopsided in favour of a few commodities. Given limited participation, a passive participant who is a forced long roller in the market may end up paying a heavy price as other participants take advantage. Globally, high roll costs have discredited a number of commodity ETFs resulting in a change in approach by fund managers.

Also, another thing that comes in the way of passive commodity products is lack of understanding about commodity markets by investors. Conversely, for savvy traders, silent passive products don’t offer any utility as they have the ability to directly trade in the commodity market to express their views. We expect this situation to get better over time as markets mature. So, over time, passive products may become more relevant.

To summarise and to answer the original question, commodities are not hype but a credible asset class that offer a great opportunity for investors. However, their behaviour and complexity mean that investors need to be careful of how they use commodities in their portfolio. In the initial phase, we expect that investors may prefer asset managers to create a single-stop multi-asset product having actively-managed commodity allocations over other, more fancy, products.

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Author: Roky