- The price of food is likely to increase over the long term but in the short term, performance is highly dependent on weather.
- Future-based agricultural funds provide excellent diversification with respect to the stock market.
- Over the past 5 years, the performances of agricultural funds have significantly lagged the S&P 500.
Why invest in agriculture? Over the long term prices for agricultural products will likely move higher because the increase in food production has not kept pace with population growth. Global population has doubled over the past 45 years and if the current 1.3% rate of growth persists, the world population will double again in 50 years. This is a lot of mouths to feed and there is virtually no more arable land or fresh water to spare. In addition, as the standard of living improves in emerging markets, people will consume more meat, which not only increases the demand on livestock but also on the supply of grain (about 5 to 6 pounds of grain is required to raise one pound of beef). New technology, such as improved fertilizer and genetically modified seeds, will help but demand is likely to outstrip supply forcing prices higher.
However, over the shorter term, weather is the main driver, which can either facilitate a bountiful harvest or cause a crippling shortage. For example, last year corn fell 40% after a record harvest while cocoa gained 21% because hot and dry weather in West Africa depressed production.
This volatile asset class is not usually associated with conservative retirement investments. However, I must confess that I like to maintain a small allocation to commodities in my retirement portfolio to add both diversification and "zing".
If you decide to invest in agriculture, the question is: what are the "best" funds to purchase. There are many ways to define "best". Some investors may use total return as a metric but as a retiree, risk in as important to me as return. Therefore, I define "best" as the asset that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.
This article will analyze a few of the agricultural Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) to assess relative risk-adjusted performance over the past few years. ETNs will be discussed in more detail later but are a cousin to ETFs and serve basically the same purpose for traders.
Most agricultural products are perishable so it is not feasible to hold the product in storage for long periods. Thus, future contracts are typically used by funds to invest in grains and livestock. To aid in understanding these funds, I will provide a quick tutorial on some of the characteristics of futures.
Futures are contracts that allow you to buy a product at a fixed date in the future for an agreed upon price. Future contracts expire and if you want to maintain a position, you have to repurchase another future contract. Depending on market conditions, the longer dated future contract may sell at a higher price than the current contract so when the current contract nears expiration, it has to be rolled over to a more expensive contract. When this happens, you lose money even though the underlying index has not changed! This characteristic of rolling over to higher priced contracts is called "contango". Similarly, if the longer dated contract sells at lower price than the current contract, you will make money when you roll over the contract. This condition is called "backwardation". The rolling methodology that a fund uses is an important driver of overall fund performance.
ETFs hold these future contracts. However, some fund companies decided not to actually hold the contracts but instead promise to provide the same return you would receive from owning the futures. These agreements are called ETNs. Since the company issuing the ETN is obligated to pay the holder the same return (less fees) as would be obtained by investing in the underlying futures, the difference between ETFs and ETNs is small (assuming the fund company does not go bankrupt).
The number of agricultural ETFs/ETNs has expanded over the past few years and it is now possible to invest in a wide range of both individual and baskets of agricultural commodities. Unfortunately, many of these funds are small and illiquid and are not suitable for most investors. The ETFs/ETNs analyzed in this article were selected based on the following criteria:
- The fund must have adequate liquidity and trade an average of at least 40,000 shares per day.
- The fund must have at least $100 million market cap.
- The fund must invest exclusively in agricultural products.
- The fund must have been launched before May, 2011 (have at least 3 years of history).
The funds that satisfied these criteria are summarized below.
- PowerShares DB Agriculture (NYSEARCA:DBA). This ETF tracks an index of 10 agricultural commodity futures. The composition of the portfolio is determined by a proprietary rule based algorithm designed to obtain the best yield from rolling over future contracts. Currently, sugar is the largest component (13%) followed by live cattle, corn, soybeans, and cocoa. Some of the smaller constituents include coffee (9.5%), lean hogs (7.6%) and wheat (6.3%). The fund has an expense ratio of 0.85% and does not provide any yield.
- ELEMENTS Rodgers International Commodity Agriculture (NYSEARCA:RJA). The ETF tracks the Rodgers International Commodity Index (RICI)-Agriculture Total Return Index, which contains 20 agricultural futures contracts. The largest components of the index are wheat (20%), corn (14%), cotton (12%) and soybeans 9%). The components in the index are reviewed and adjusted annually. The fund has an expense ratio of 0.75% and does not provide any yield.
- iPath DJ-UBS Grains TR Sub-Index (NYSEARCA:JJG). This is an ETN that provides returns that are commensurate with the performance of unleveraged investments in grain future contracts. The index is composed of 41% corn, 37% soybeans, and 22% wheat. The fund has an expense ratio of 0.75% and does not provide any yield.
- iPath DJ-UBS Coffee TR Sub-Index (NYSEARCA:JO). This is an ETN that provides returns that are commensurate with the performance of unleveraged investments in coffee future contracts. The fund has an expense ratio of 0.75% and does not provide any yield.
In addition to ETFs and ETNs that are based on futures, the following is an ETF that offers global exposure by investing in companies supporting the agriculture industry.
Market Vectors Agribusiness (NYSEARCA:MOO). This ETF holds 51 stocks that are associated with agriculture, including farming equipment, fertilizer, and seeds. The fund uses a modified cap weighting and the largest 10 holding make up almost 60% of the total assets. About half the portfolio is domiciled within the United States. The fund has an expense ratio of 0.55% and yields 1.9%.
I first looked at funds that had a 5 year history and used the Smartfolio 3 program (www.smartfolio.com) to plot the rate of return in excess of the risk-free rate (called Excess Mu on the charts) versus historical volatility. The results are shown in Figure 1.
Figure 1: Risk versus reward past 5 years.
The figure indicates that there has been a wide range of returns and volatilities associated with these agriculture funds. For example, coffee had the largest volatility but also had a larger return than many of the other funds. Was the increased return worth the increased risk? To answer this question, I calculated the Sharpe Ratio for each fund.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of DBA, which is the most popular agriculture ETF. If an asset is above the line, it has a higher Sharpe Ratio than DBA, which means it has a higher risk-adjusted return than DBA. Conversely, if an asset is below the line, the reward-to-risk is worse than DBA.
Some interesting observations are apparent from the plot. Over the past 5 years, the agriculture fund based on stocks easily outpaced all the funds based on futures. This is not too surprising since the stock market had been in a strong bull market during the look-back period. All the other ETFs/ETNs had similar risk-adjusted performance with JJG being the best and DBA lagging. Coffee was about twice as volatile during the period as DBA but since it is above the red line, the returns were commensurate with the risk.
Since all the funds being analyzed were associated with agriculture, I wanted to see if you received any diversification by investing in multiple offerings. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. I also added the SPDR S&P 500 (NYSEARCA:SPY) ETF to assess the correlation of the funds with the S&P 500. The results are provided in the 5 year correlation matrix shown in Figure 2. None of the funds, with the exception of MOO, were substantially correlated with the overall stock market. Thus, a general market portfolio will receive diversification benefits from adding these future based funds. As you might expect, MOO was highly correlated (86%) with the stock market but was not correlated with the other funds. Among themselves, the broad based basket funds (DBA, JJG, and RJA) were all highly correlated with each other, suggesting you do not receive significant diversification by investing in more than one. The price of coffee was only slightly correlated with the other funds.
Figure 2. Correlation matrix over past 5 years
Next I wanted to assess if the performance changed if we reduced the look-back period to more recent times. I re-ran the analysis over the past 3 years from May, 2011 to May, 2014. For this period, I added the following ETF that was launched in 2010.
Teucrium Corn (NYSEARCA:CORN). This ETF tracks the price of corn futures by holding a portfolio of 3 separate corn future contracts (with expiration in different months). The use of separate contracts helps the fund manage roll. The fund has an expense ratio of 1.4%% and does not provide any yield.
The risks versus rewards for the 3 year look back period are shown in Figure 3 and what a difference a couple of years made! Over this period, only MOO was able to stay above water (but not by much) and JJG performed better than the other future based funds. The Sharpe Ratio is not useful when looking at negative returns but a few conclusions can still be gleamed from the plot. DBA and RJA had similar performance but lagged JJG. CORN has not performed well since its debut but it still outperformed coffee, which endured a rough bear market. Coffee had a terrible year in 2013, posting the longest stretch of declines in over 20 years. This down trend was due to Brazil having a banner crop year, which flooded the market with supply.
Figure 3: Risk versus reward past 3 years
If we narrow our view to the past year (May 2013 to the present), then the performances have slightly improved. As shown in Figure 4, most funds, with the exception of CORN, have pulled themselves back into positive territory. Coffee has soared higher, due to a dry spell in Brazil, which underscores that agriculture futures can sometimes turn on a dime, with steep losses in some periods followed outsized gains in others.
Figure 4: Risk versus reward past 12 months
Agricultural funds do provide diversification, with shorter term performance more dependent on weather than economic trends. This volatile asset class is not for the faint hearted and I would recommend these funds only for the more risk tolerant investor.