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Are Agriculture ETFs Ripe for the Picking?

Agricultural commodities have seen increased investor interest due to escalating demand and diminishing supply as populations continue to grow and arable land grows scarcer

Lee Davidson 7 August, 2012 | 3:36PM

'Hell hath no fury like a woman scorned', especially when that woman happens to be Mother Nature. In the US Midwest, the most severe drought in the past 50 years has wreaked havoc on expectations for corn and soybean yields. On July 30th, citing extremely hot and dry conditions, the US Department of Agriculture slashed estimates for the portion of the US corn crop deemed "good" or "excellent" down to 24% compared with 66% on June 11th of this year and 62% at this time last year.

With heightened expectations for a fall in corn yields, corn and soybean prices have skyrocketed. In Europe, ETFs and other exchange-traded products (ETPs) tracking short-term corn futures rose some 60% in aggregate during June and July. If extreme weather conditions persist into August, corn and soybean prices may face even more upward pressure in the short term. For those investors who have yet to buy into the agricultural commodity space, a reasonable question to be asked is whether or not there is additional near-term upside in agricultural commodities and what long-term role they might play in a diversified portfolio.

The Case for Agricultural Commodities
Looking back over the last few years, agricultural commodities have seen increased investor interest due to escalating demand and diminishing supply as populations continue to grow and arable land grows scarcer. This trend is captured most succinctly with the stocks-to-use ratio which indicates the level of carryover stock for a given commodity as a percentage of the total use of that commodity. This metric reflects how much “bread” the world has in its collective “bin” at any given point in time. For worldwide grain supply, the stocks-to-use ratio has been in decline since reaching a peak at roughly 35% in 1987. This figure currently stands at 21% in 2011. In July, the USDA projected that the stocks-to-use ratio for total grains worldwide would slide further to 19% in the current production year. This leaves the world’s farmers with little margin for error and, with so little “bread” in the “bin”, also leads to extreme volatility in agricultural markets.

While the rate of population growth is expected to decline over the next few decades, population growth is still expected to be positive. In fact, the World Bank predicts that within the next 35 years roughly 2.1 billion people will be added to the current population of some 7 billion. The absolute increase in population levels implies a greater need for food. Furthermore, as emerging market populations shift their diets towards greater meat consumption, which requires nearly four times as many resources compared to plant-based diets, demand for grains should strengthen further. According to the Food and Agriculture Organization of the United Nations, food production must increase by 70%, with a confidence band of 60%-100%, by 2050 simply to keep up with the expected population growth.

Food production, however, is not the sole driver of agricultural commodity demand. With the rise of the ethanol industry in the US and elsewhere, agricultural commodities have been increasingly swept up in the search for feasible alternatives to fossil fuels. Demand from the biofuel industry has buoyed demand for agricultural commodities in recent years with US ethanol production increasing 20% in 2010 and 6% in 2011. The percentage of the total corn crop used for ethanol production has risen from 25% in 2009 to a forecast level of roughly 37% in 2012 within the US. Despite the ramp-up in ethanol production, the USDA estimates that ethanol now represents just under 10% of US motor vehicle petrol supplies. Despite the expiration of the ethanol subsidy in the US at the end of 2011, the US Environmental Protection Agency is still predicting a 7% increase in ethanol production for 2012. As biofuel innovators continue to compete with consumers for agricultural resources, agricultural commodity prices will continue to be supported.

It seems clear that demand for food stuffs is poised to rise and perhaps alternative fuels as well, but will supply rise to meet it? Increasingly, most evidence seems to indicate that supply will struggle to keep up. The growth in global grain yields has fallen off from a 3.5% pace in 1970 to 1.5% today, likely due to the natural limits imposed by biology. Rich-world producers of rice (Japan) and wheat (France, Germany and UK) have failed to increase yield/acre ratios for the last 10 years indicating that innovation and new technology may only improve production up to a certain point.

As producers approach a productivity ceiling, the availability of crucial inputs is also on the decline. Potash and phosphate fertiliser reserves are finite and being depleted, which is worrisome since these minerals (potassium and phosphorous) cannot be artificially manufactured. With the upper bounds of production being tested and resources running out, simply meeting expected global food demand regardless of cost will be a long-term challenge.

Commodities and Your Portfolio
For the long-term investor, demand for agricultural commodities could translate into higher prices. But how else can a commodity investment complement an already well-diversified portfolio?

From a portfolio construction perspective, commodities as an asset class have historically been sought out by investors to increase their risk-adjusted returns given their low to negative correlation with equities and fixed income securities. In recent years, however, investors have seen five-year trailing correlations for agricultural commodity indices go from near 0% in 2006 to upwards of 50% today (measured against the STOXX Europe 600 and MSCI World indices).

Despite this rise in correlation to equities, commodities have not lost all their investment appeal from a portfolio construction standpoint. Commodities still offer the clearest and most effective hedge against unexpected inflation. Since 1998, broad commodity allocations have proven to be positively correlated with unexpected inflation (~67%) and can be a suitable investment to meet this strategic need.

ETPs are an extremely competitive vehicle to consider filling a commodity sleeve of a portfolio given their structural advantages as low cost, low-turnover and broadly diversified funds. Due to the high carrying costs associated with holding many agricultural commodities, most agricultural commodity ETPs track futures-based indices to gain exposure. Tracking a futures-based index implies that an ETP will have three unique sources of return: spot price return, collateral yield and roll yield. Collateral yield is generated via interest payments from US Treasury bills, which are typically held as collateral backing the commodity futures’ positions. Roll yield is generated when selling expiring futures contracts and purchasing the next contract. Depending on the price of the next futures contract, the index could either experience positive roll yield when the relevant futures curve is in backwardation or could experience negative roll yield in contango markets. To learn more about the basics of investing in commodities via ETPs, you can watch our recent webinar on the topic.

ETPs for Investing in Agricultural Commodities
In Europe, the menu of ETPs offering exposure to agricultural commodities is extensive. Amongst this extensive crop of ETPs, we think that long-term investors should benefit from a focus on vehicles that implement dynamic rolling methodologies. Dynamic rolling methodologies seek to minimise the adverse effects of contango and maximise the positive effects of backwardation in futures markets. Over time, these methodologies should produce superior performance compared to more common “naïve” rolling methodologies. Examples of ETPs utilising dynamic rolling methodologies in the European ETP space include the db Agriculture Booster ETC (XCT6), the iShares S&P GSCI Dynamic Roll Agriculture Swap (SDRA), and the RBS RICI Enhanced Agriculture Index ETF (9J6J). 

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Morningstar ETF Invest Conference Europe 2012
Thought Leadership from the Leaders in the ETF Space

Morningstar’s Inaugural ETF Invest Conference Europe will feature some of the sharpest minds in ETF management and top pundits to help sort out the complexities, alternative theories, and investing strategies using ETFs. The event features keynote presentations, and general discussions, on key areas of strategic and tactical investing solutions. The conference will also give you the opportunity to develop and expand your professional network by conversing with fund managers, analysts, providers, and other financial industry experts.

For full details visit the conference web site here. 

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About Author Lee Davidson

Lee Davidson  is an ETF analyst with Morningstar Europe.