Will ICICI Multi-Asset Fund become more volatile with Commodity Derivatives?

Will the inclusion of Exchange-Traded Commodity Derivatives in ICICI Multi-asset fund make it more volatile than before? A discussion

paint rollers with different colors on a wall representative of the change in investment strategy of ICICI Multi-asset fund

Published: February 26, 2020 at 3:07 pm

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ICICI Mutual Fund has announced changes to the fundamental attribute of ICICI Multi-Asset Fund effective March 28th 2020. Will these changes make the fund more volatile? A discussion.

Those who do agree with these changes can exit the fund without load (but will have to pay applicable tax) from Feb 27th 2020 to March 28th 2020.  While there is no change in the name, investment objective and benchmark of the fund, there are the major changes.

The fund can now invest in:

  1. Debt oriented mutual fund schemes.
  2. Exchange-Traded Commodity Derivatives up to 30% (min 10%). 
  3. Preference Shares (up to 10%).
  4. Physical gold is no longer an investment option, only gold ETFs (which is a commodity). This should not impact the unitholder much.

Since preference shareholders receive a pre-defined dividend rate,  AMCs can create a dividend income streams for the fund but at this exposure level, it should make an impact one way or another. If the underlying business gets into trouble, AMCs will not be able to sell these freely. It is a form of unsecured debt (dividends replacing the bond interest).

SEBI allowed mutual funds to invest in the commodity derivatives market from May 2019. With Tata AMC coming up with its own multi-asset fund that can invest in Exchange-Traded Commodity Derivatives (NFO closes 28th Feb 2020), the timing of this change to ICICI Multi-Asset is intriguing, to say the least.

With this announcement, Tata AMC can no longer claim to be the pioneers in mutual fund participation in the commodity exchange! These are the Exchange Traded Commodity Derivatives that are allowed: Gold, Silver, Aluminum, Copper, Lead, Zinc, Nickel, Brent, Crude Oil and Natural gas, Edible Oil – Soy, bean, Soy Oil, Mustard Seed and Crude Palm Oil, Castor Seeds, Coon and Coon Seed Oil, Cake, Guar Gum, Cumin Seed and Turmeric.

What is an Exchange-Traded Commodity Derivative (ETCD)? This is a regulated platform for trading in commodity derivatives (or derived products like futures, swaps etc). These are products that depend on an underlying asset without the physical presence of the asset. Multi-asset funds can hold up to 30% of ETCDs,

A mutual fund can either hold a commodity (long position) or engage in an arbitrage buy/sell in the spot market and sell/buy futures in the derivative market. This is known as cash-n-carry arbitrage (there are other types too). See a detailed write up here: How Arbitrage Mutual Funds Work: A simple introduction

Regulated commodity trading is quite new in India. The Multi Commodity Exchange of India Limited (MCX) began operations in Nov 2003; SEBI got full control only in 2015. This is a history of such trading. Due to this and also due to factors unique to each commodity,  ETCDs and associated arbitrage bets can be expected to be significantly more volatile than corresponding stock or bond bets.

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As an example, the figure below shows the 30-day rolling return of MCX iCOMDEX a commodity composite index and Nifty 50 futures. The actual returns should not be compared as the  MCX iCOMDEX is an excess return index, whereas the Nifty 50 futures only tracks the price.

Excess return index measures the growth of a commodity futures contract when it is rolled over (or extended). It measures the change in the price of the contract plus the profit or loss from rolling over the contract. It is called excess return because the return of this index is over and above any interest earned from collateral placed to create the futures contract.

It is reasonable to compare the extent fluctuations in both and clearly commodities are more volatile. Two things are to be kept in mind. (1) Mutual funds would use arbitrage to eradicate most of this volatility (only half of the arbitrage deal is shown here) (2) Notice that sometimes the commodity index moves out of step with Nifty futures. This is why the AMCs claim ETCDs can be used for diversification and possibly lower volatility.

30 day rolling returns of MCX Icomdex composite compared with NIfty 50 Futures
30 day rolling returns of MCX Icomdex composite compared with NIfty 50 Futures

Liquidity (ease of selling) is expected to be lower for ETCDs and if there is a physical delivery of the commodity involved, political, climatic or other factors come into play (settlement risk). Just as we are finding out the impact of credit defaults in the bond market, we are likely to learn a thing or two about ETCDs via multi-asset mutual funds.

ETCDs pave the way for higher arbitrage returns but also come associated with risks of volume and settlement risk. Is it really necessary especially when effective diversification can be done with gold which tends to do well when there is fear in the stock market?

Clearly the answer is no. These changes are undesirable and needless. As usual, the unitholder is the guinea pig while the government (via SEBI) wants to deepen different markets (first bonds and now commodities).

It is reasonable to expect ETCDs to make mutual funds a bit more volatile. However, this volatility may not be visible on a day to day basis due to the direct equity and gold exposure. It may show up when the direct equity in the portfolio is significantly lower (replaced with equity arbitrage).

Undesirable as this change in attribute of ICICI Multi-asset maybe, investors need not be worried and continue to hold the fund. This is only my central holdings and I intend to stay put.

As long as these funds do not abandon gold for other commodities, the associated risk should be bearable by the investor and manageable by the AMC. It would have been better if specific limits of Gold in the portfolio is defined. Interesting times ahead!

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