During the heyday of paper assets, stockbrokers regularly lorded over their commodity-dealing brethren. It wasn't personal, mind you, just the nature of the business. Stock jockeys were making commissions hand over fist, leaving commodities brokers to wonder about the sagacity of their career choice.
Now the shoe seems to be on the other foot. Or, better put, the glove is on the other fist. Commodities' popularity with retail investors ebbs and flows with the inflation cycle. As inflationary pressures build, stocks and bonds cheapen; futures prices, in contrast, rise. And futures prices have been on a long tear, sending commodity brokerage commissions skyward.
This trend may have legs, too, if Jim Rogers is to be believed. Rogers, once a partner of George Soros in the Quantum Fund, and an author and financial commentator, has been a long-time advocate for commodities in his books and articles. Research done for his latest book, Hot Commodities: How Anyone Can Invest Profitably In The World's Best Market, argues that the current bull market for commodities could stretch well into the next decade. On average, says Rogers, market leadership shifts between equities and commodities every 18 years. Commodities started gearing up in 1999, leading Rogers and his adherents to believe the cycle won't end until 2017 or so.
Certain commodities have long been staples of financial news reports. Every twitch and tremor in the prices of gold and crude oil, for example, were breathlessly reported last year. For good reason, too. At the beginning of 2007, gold's price was fixed by London dealers at $641 an ounce. By year's end, an ounce of bullion fetched more than $836. Holding gold, before costs, would have afforded an investor a nearly 31-percent gain for the year. Spot crude oil fared even better, rising 58 percent in 2007. With blue-chip stocks off their 52-week highs by almost 14 percent, it's no wonder that some stockbrokers took up studying for the Series 3 National Commodity Futures Exam.
Some commodities, though, fared even better than gold and crude oil. Agricultural commodities, such as wheat and soybeans, shot up 77 percent and 80 percent, respectively. Getting clients into bonanzas like grains and oilseeds, until now, usually meant finding the stocks of companies involved in commodity production. That might mean buying integrated producers and processors, including Archer-Daniels-Midland (NYSE: ADM), agrichemical outfits like Mosaic Corp. (NYSE: MOS) or equipment manufacturers such as Deere & Co. (NYSE: DE).
These stocks have been direct beneficiaries of the recent boom in agriculture, but purer plays — unalloyed with equity risk — are now available to clients of stockbrokers and financial advisors. Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) tracking agricultural futures were launched last year along with other instruments designed to slice and dice the commodities market.
Too Risky? Nah
Commodities are often shunned as portfolio constituents because of their perceived riskiness. In actuality, the price volatilities exhibited by the newfangled agricultural instruments have been lower than those of individual agribusiness stocks. (See table.)
This falls in line with seminal research conducted by Gary Gorton, a Wharton finance professor, and K. Geert Rouwenhorst, of the Yale School of Management. Their paper, titled, "Facts and Fantasies about Commodity Futures," examined the risks and returns of commodity futures, stocks and bonds over nearly five decades.
To measure risk, the researchers built an equally weighted index covering more than three dozen domestic and foreign commodity contracts traded between July 1959 and December 2004. The Yale futures index actually displayed less risk than stocks in the 45-year span examined. Commodities exhibited a standard deviation of only 12 percent compared to 15 percent for the S&P 500. (A bigger standard deviation means an investment is more volatile, with wider swings up and down.)
And, anyway, are commodity stocks actually a good substitute for futures themselves? The Wharton/Yale study attempted to match publicly traded companies engaged in the production of commodities with futures on the underlying products. Of the 17 historical matches found, the cumulative performance of futures significantly exceeded the cumulative returns of their corresponding equities. In fact, the correlation between commodity prices and commodity stocks was fairly low — lower, in fact, than the correlation to the S&P 500. It seems that commodity company stocks act more like other stocks than futures — making them a rather poor substitute for commodity investments.
More Ways To Play
There are an increasing number of ways to play the agricultural (NYSE:AG) commodities game, affording investors and advisors the opportunity to dial in the level of agricultural-market exposure desired. Some ETFs, based upon futures or stocks, together with ETNs, cover the entire agribusiness segment. Others focus on narrower sectors, even funneling down to just a trio of grains.
AG ETFs, like their equities counterparts, track underlying indexes through replication. Two of the five AG instruments launched last year are ETFs. One represents a portfolio of futures, the other a collection of stocks. Consistent with the findings of the Yale/Wharton study, the equity-based ETF exhibits a significantly higher correlation to the stock market than the futures-based fund. Investors looking for the much-touted diversification benefit of commodities are more likely to find it in the futures product. ETFs pass the tax consequences of the underlying investments to their investors (tax treatment follows the mutual fund model).
Futures ETF owners, however, must contend with annual marking-to-market, in which all open portfolio positions are deemed "sold" on the last business day of the year, and "repurchased" on the first business day of the following year. Resulting gains and losses are treated as 60 percent long term and 40 percent short term, meaning top-bracket taxpayers settle with the IRS at a blended 23-percent rate.
Three of the new AG instruments are ETNs, zero-coupon structured notes that represent promises to repay, at a maturity that is 20 or 30 years from flotation, the issue price plus the accumulated appreciation of the target commodity index. With ETNs, there are no actual portfolios managed. There are therefore no "frictional" portfolio costs: no slippage, no tracking error and no interest distributions. Deemed "prepaid contracts," tax settlement is due upon sale, redemption or maturity, at long-term or short-term rates, based upon the holding period.
Contango: Dancing For Dollars
All instruments tracking a futures index, ETFs and ETNs alike, must contend with the effects of contango and backwardation. Contango describes the relationship between a commodity's delivery months in which the price for the near-term delivery is lower than that of the deferred contract. If, for example, April gold is trading at $900, and October gold is $935, you can say there's a $35 contango. That contango also represents the potential loss if you "rolled" a long position to October: You'd sell April at $900, and buy October at $935.
Rolling forward is precisely what a futures index must do regularly to maintain constant exposure in its constituent commodities. As delivery dates approach, expiring contracts are sold, and the next active contracts purchased. When a market is in contango, the "roll yield" is negative, reducing the index's overall return.
There are times when the reverse is true. Price relationships sometimes invert, making nearby contracts more expensive than deferred deliveries. This backwardation often develops when supply shortages are forecast. When April crude oil trades at $95, while the May contract changes hands at $97, the roll yield turns positive, enhancing index returns.
POWERSHARES DB AGRICULTURE FUND (NYSEARCA:DBA)
The PowerShares DB Agriculture Fund was launched in January 2007, the first of its kind. Based upon a sub-sector of the Deutsche Bank Liquid Commodity Index, the fund is an equally weighted portfolio of futures contracts on the most liquid and widely traded agricultural commodities, including corn, wheat, soybeans and sugar. DBA's annual expense ratio is 0.75 percent.
VAN ECK MARKET VECTORS AGRIBUSINESS ETF (NYSEARCA:MOO)
Next out of the chute, in August 2007, was an ETF tracking the DAXglobal Agribusiness Index. The index is stock-based, providing exposure to 40 worldwide companies in five segments: agricultural chemicals, agriproduct operations, agricultural equipment, livestock operations and ethanol/biodiesel production. The top five components, by market weight, include: Mosaic Co., Potash Corp (NYSE:POT), Monsanto Corp. (NYSE:MON), Deere & Co. and Archer-Daniels-Midland. MOO's expense ratio is capped until April 2008 at 0.65 percent.
ELEMENTS ROGERS INTERNATIONAL COMMODITY INDEX AGRICULTURE ETN (NYSEARCA:RJA)
In October 2007, agriculture ETNs made their first appearance with the launching of a note tracking a 20-commodity subset of the Rogers International Commodity Index. Futures on wheat, at 20 percent, make up the largest index component, followed by corn, cotton, soybeans and coffee. These five markets comprise two-thirds of the index's weight. RJA's annual investment fee is 0.75 percent.
IPATH DOW JONES-AIG AGRICULTURE SUB-INDEX ETN (NYSEARCA:JJA)
A seven-component split of the Dow Jones-AIG Commodity Index is tracked by a Barclays Bank-issued ETN launched in October 2007. Soybeans, at 31 percent, represent the weightiest commodity tracked by the underlying index, followed by wheat, corn, soybean oil and cotton. The annual expense for JJA runs 0.75 percent.
IPATH DOW JONES-AIG GRAINS SUB-INDEX ETN (NYSEARCA:JJG)
Launched alongside JJA, the index underlying the JJG note carves out three commodities from the Dow Jones-AIG Agriculture Sub-Index to offer the narrowest target among the current generation of AG instruments. Soybeans take up 46 percent of the index weight, while wheat and corn split the remainder. Like its broader-based stable mate, JJG charges an annual investment fee of 0.75 percent.
George Washington once wrote, "I know of no pursuit in which more real and important services can be rendered to any country than by improving its agriculture." Now that investments in agriculture are no longer the exclusive purview of Series 3-wielding brokers, perhaps financial advisors can do more to improve their clients' portfolio results in inflationary times.
What's the "Sharpest" Agriculture Play?
† Return is shown for the 107-trading day period October 25, 2007 - March 31, 2008, then annualized for calculation of the Sharpe ratio.
Source: Brad Zigler
Web Resources for AG investments