The Problem With Agricultural Commodity ETFs

Includes: COW, DBA, MOO
by: Kay McDonald

The wheat commodity trading went crazy recently due to the drought, fires, and export ban announcement from Russia. The region experiencing a crop failure is referred to as "agriculturally risky" since it experiences droughts approximately two out of every five years. Even so, wheat supplies appear to be adequate for now and higher prices always mean a response of increased plantings, and thus, production.

Related to the recent Russian wheat disaster, on August 3rd, Jim Rogers told CNBC in a phone interview that "agricultural commodities have been too low for too long" and that "prices of nearly all agricultural commodities are set for steep rises." Though considered a "guru" by many, I questioned his credibility last January, when he told CNBC that "The inventories are now at the lowest they've been in decades, not in years," and agricultural commodity prices are set to "go through the roof," when in fact, global grain levels were actually high at the time.

My view remains bearish on agricultural commodities as well as farmland prices, as it was more than a year ago. This is based upon expectations of continued difficult global macro economic deflationary challenges, along with increased production trends from South America and elsewhere. Production is policy driven and in our debt-laden futures, farm policy will be stressed. There are already such hints coming from Collin Peterson and others who are working on the rewrite of the 2012 Farm Bill. Of course, there are always the wild-cards of weather and energy prices which are difficult to predict.

Since it feels like there's no place to hide with your savings these days it would seem logical to invest in commodities which should have real value in times of hardship. Many of today's distraught investors have chosen agriculture for diversification. Much has been written of late, here at Seeking Alpha and elsewhere, advising investment in agricultural ETFs. The ETF investment vehicle has been long regarded as a low-fee representative store of sector value with easy small investor access.

Business Week's July 22, 2010 cover story, Amber Waves of Pain warns investors that when commodities go up, commodity ETF's often don't.

From the article:

Contango isn't the only reason commodity ETFs make lousy buy-and-hold investments. Professional futures traders exploit the ETFs' monthly rolls to make easy profits at the little guy's expense. Unlike ETF managers, the professionals don't trade at set times. They can buy the next month ahead of the big programmed rolls to drive up the price, or sell before the ETF, pushing down the price investors get paid for expiring futures. The strategy is called "pre-rolling."

"I make a living off the dumb money," says Emil van Essen, founder of an eponymous commodity trading company in Chicago. Van Essen developed software that predicts and profits from pre-rolling. "These index funds get eaten alive by people like me," he says.

A look at 10 well-known funds based on commodity futures found that, since inception, all 10 have trailed the performance of their underlying raw materials, according to Bloomberg data.

Business Week uses the U.S. Oil Fund (NYSEARCA:USO) ETF as an example of what can happen to a commodity ETF. It has dropped fifty percent since its inception April 2006, during which time period crude oil has risen eleven percent. Also, it cites the total return on the DB Agriculture Fund (NYSEARCA:DBA) being 3 percent since January 2007, while the weighted average of its commodity components has risen 19 percent.

If you are an investor in Ag commodity ETFs or are thinking about becoming one, the above 7-page article is a must-read. Then, when you are done with that article, to find out about the up-and-coming, newfangled, derivative-laden, quant-created extreme-ETFs, read ETFs Gone Wild from Bloomberg. The good old John Bogle days of simple index investing followed by the popularity of exchange-tranded funds, or ETFs, was just too tempting of a target for the vultures who wished to participate.

In essence, just when you thought the investment interests couldn't become more stacked against the small investor in plain sight of government regulators, it has hit a new low in the ETF area. As always, if you make any investment decision, you simply must understand the product and read the warnings in the prospectus.

Disclosure: No positions.