Whither Commodity Stock Funds?

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Includes: ADM, DBA, MOO
by: Hard Assets Investor

By Brad Zigler

Feline fans hate to hear the phrase, "There's more than one way to skin a cat," but investors still use it to explain the alternative routes taken to some of their portfolio exposures.

You want a commodity allocation without having to open a futures account? You could buy the stock of a commodity producer, such as Archer Daniels Midland (NYSE: ADM). Or you can cast a wider net with an investment in an industry fund, like the Market Vectors Agribusiness ETF (NYSE Arca: MOO). Alternatively, you can try an index product that holds the commodities themselves (or, rather, futures as commodity proxies), such as the PowerShares DB Agriculture Fund (NYSE Arca: DBA).

With these choices available, it's incumbent upon investors to ponder the relative merits of each instrument, so that the desired exposure can be most efficiently delivered. And while each investment's recent performance can be analyzed for clues, it ought to be remembered that the past doesn't always repeat itself. Let's look at some examples:

ADM

MOO

DBA

1-Year CAGR

28.8%

64.6%

5.4%

Annual. Volatility

46.6%

45.4%

28.7%

Sharpe Ratio

0.62

1.42

0.18

Buying ADM (Individual Stock)

Buying a single issue is an extremely risky move; put simply, you could end in the right neighborhood, but knocking on the wrong door. That's precisely what happened with an investment in ADM,

ADM is one of the largest components (7.5 percent) of the index tracked by MOO, although its return was swamped by other components in the portfolio. At 28.8 percent, the stock's compound annual growth rate last year was not too shabby, but it's still a rather middling track record for a MOO component, actually. And for the volatility undertaken—46.6 percent—an investment in ADM didn't offer the best risk-adjusted return.

Looking at ADM's 0.62 Sharpe ratio measures the "cost" of the stock's excess return—that is, its gain above the T-bill rate—per unit of risk. (Generally speaking and without considering other metrics, a Sharpe ratio of 1.00 represents "good" compensation for risk, and the higher the ratio, the lower the return's cost.) While not "bad" per se, ADM's performance still wasn't all that good.

Buying MOO (Agribusiness Stock ETF)

With an index-based fund, you're automatically taken to the neighborhood and forced to knock on all of its doors, therefore removing any stock-picking or management risk. The common complaint voiced by so-called active investment managers is that index-based investments are doomed to deliver only "average" (often defined as "mediocre") performance. That may be true, but as we've seen with ADM, an investor's stock-picking skills can also be subpar.

Over the past year, MOO's share value rose at 64.6 percent rate, indicating that some of the 46 companies comprising this fund's modified cap-weighted portfolio had outgunned ADM by a wide margin. Indeed, the growth rate of MOO's largest component—Potash Corp. of Saskatchewan (NYSE: POT)—was 49.7 percent last year. Even with its higher volatility, POT's risk-adjusted return was higher than ADM's.

Overall, the reward-to-risk ratio for the sector-bet MOO portfolio was higher than a wager on most of its component stocks.

Buying DBA (Futures-Based ETF)

Investments in commodity stocks really represent two bets: one on the commodity returns that filter down to the issuers' bottom lines, and another on the stock market itself. Futures, on the other hand, are a purer play: You're wagering on commodity returns alone (well, in truth, you're really not adding the equity bet).

Futures are typically described as high-risk investments, owing to their inherent leverage, since traders can undertake positions with very small performance bond (margin) deposits. But that's not how a futures ETF invests. The fund makes fully collateralized commitments to its futures positions by depositing the full contract value in T-bills with the carrying broker. Thus margin calls are avoided.

But that doesn't mean risk is eliminated. Obviously, a long bet on the 11 agricultural and livestock futures owned in the DBA portfolio can be sometimes be wrong. But even when it's right, returns may be less than stellar, owing to the shape of the futures curve. Even though the DBA index methodology is designed to minimize the deleterious effect of normal market contango, it doesn't obviate it completely. Expiring futures can still be rolled over into later-dated contracts at a loss. This is especially true of agricultural commodities, because deliveries for different crop years are simultaneously on offer; and due to various market and weather expectations, pricing may change drastically between the last month of the nearby crop year and the next crop year's front month.

Contango's effect has been realized in the DBA portfolio, even though it contains one of the fastest-rising commodities on the ag landscape—sugar. In sum, the DBA portfolio brought up the rear in the performance derby, with a growth rate of only 5.4 percent. DBA's price volatility—about two-thirds of the stock-based MOO portfolio—helped to boost the futures fund's Sharpe ratio, but DBA still ends up looking relatively weak.

A Momentum Shift?

The recent weakness of futures-only funds compared to their equity-based analogues can be better seen when mapping a given stock fund's relative strength to its futures-based counterpart. Below, the green line tracks the strength of MOO's price trend vs. DBA's over the past year. The red line charts the course of a broader-based commodity stock fund—the Market Vectors RVE Hard Assets Producers ETF (NYSE Arca: HAP) compared to the 17-commodity GreenHaven Continuous Commodity Index ETF (NYSE Arca: GCC).

Commodity Stock ETFs' Relative Strength

Commodity Stock ETFs’ Relative Strength

Over the past year, the trajectory has been up for both equity funds, meaning they've outperformed their futures-based counterparts. Momentum, though, has recently slowed, especially for the broader-based HAP portfolio.

Much of that can be attributed to the bullishness in the precious metal markets tracked by the GCC portfolio; the smallish contango in the gold market especially helps. In fact, the COMEX gold contango has actually been shrinking over the past few trading sessions, reflecting the keen demand for the nearby December delivery.

The chart also raises the question of a trend reversal: Will the stall turn into a rout? Will futures funds move into the ascendency and force the relative strength lines back down?

Two factors will determine the chart's future course. First, there's the buoyancy of the equity markets. The recent vigor in the risk trade has been a fresh breeze for the HAP and MOO portfolios, but a downturn in equity interest could stall the futures-based funds' sails.

Second, and probably more important, is the demand for commodities. If supply tightness develops, commodity markets are more likely to invert, creating positive roll yields along with higher prevailing prices. That would leverage the returns on futures-based funds.

Whether this makes cat fanciers happier is anybody's guess.