Agricultural ETFs: Demand, Inflation, and the Dollar

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Agricultural ETFs track the price of agricultural commodities. Because commodities are non-productive, non-income generating assets, investing in agricultural ETFs is a pure bet on prices. Agricultural commodity ETF investors believe that livestock, corn, soybeans, coffee, cocoa will become more expensive over time.Over the long run this has not been the case. Thanks to modern farming technology, a bushel of wheat today is much less expensive today than a bushel of wheat a hundred years ago.But how have agricultural commodity ETFs performed over the more recent term? The chart below compares the price of the Deutsche Bank Agriculture ETF (NYSEArca:DBA - News), which holds futures contracts on coffee, cocoa, sugar, and live cattle, with the domestic equity benchmark, the Standard and Poor's Depositary Receipts on a 1-year basis.

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As the chart shows, DBA is outperforming the SPY. What accounts for this outperformance? First, after decades of declines, inflation increased over this period shown in the chart. Second, the dollar weakened over the period. Third, although demand for basic agricultural commodities is somewhat inelastic, increasing global output has increased demand and boosted commodity prices. Some investors believe that an emerging and hungry middle class in China and India has permanently shifted the demand curve for agricultural commodities.Powershares Deutsche Bank U.S. Dollar Index Bullish (NYSEArca:UUP - News) tracks the dollar against a basket of currencies. The chart below compares DBA with UUP.

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As the chart shows, DBA is negatively correlated with the dollar. As the dollar strengthened early summer of 2010, commodity prices fell. When the dollar subsequently weakened, DBA strengthened. This inverse relationship is not unusual for commodities. Commodities ETFs are useful therefore for adding diversity a portfolio. They can be a good inflation hedge and dollar hedge.In addition systematic risk, commodity ETFs have rollover risk, sometimes called the cost of carry. Commodity ETFs hold futures contracts that are rolled over before they expire. In a market in contango the spot price is lower than the futures price, so ETF managers must pay a premium to roll over futures contracts. Although this trade can sometimes be manipulated by commodities traders, by staggering their futures dates, ETFs are getting better at managing this risk. When commodity ETFs get very large, liquidity in the futures markets becomes less available.For some investors this impact may be muted, ironically by what some regard as a further problem with commodities ETFs: their tax structure. Unlike stock and bond ETFs, commodity ETFs are formed as partnerships and therefore issue K-1 forms. Because partnerships are pass-through entities, gains and losses in the fund are passed through to the fund's partners. This generates either tax gains or losses regardless of the performance of the fund. If gains are generated, tax due needs to be funded from other sources. If losses are generated, tax losses may be used to offset other income. In a contango situation, roll-over losses may be expressed as partnership losses on a K-1, providing investors with losses to offset gains elsewhere, thereby mitigating losses due to contango somewhat.An alternative to investing in commodity futures based ETFs is investment in the ETFs that hold companies in the agricultural sector. The Market Vector Agribusiness ETF (NYSEArca:MOO - News) and Guggenheim Timber (NYSEArca:CUT - News) are examples . MOO's holdings for example include fertilizer and feed products producer Potash (NYSE:POT - News) and agricultural products giant Monsanto (NYSE:MON - News). The chart below shows how MOO compares to DBA and the SPY over the same period.

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As the chart above shows, MOO's performance over the last twelve months is between the equity benchmark SPY and the futures-based commodity fund DBA. MOO tends to provides a less volatile way of providing investors with exposure to the commodity sector.In addition to ETFs, several ETNs track agricultural commodities. These ETNs are popular with investors who seek concentrated exposure to individual commodities rather than to the agricultural sector as a whole. In addition to being far more speculative than aggregate baskets of commodities, these ETNs carry counter-party risk.Below a list of agricultural commodities ETFs and ETNs and their expense ratios:BROAD COMMODITYPowerShares Deutsche Bank Agriculture (NYSEArca:DBA - News), 0.85%GreenHaven Continuous Commodity Index Fund (GCC), 1.08%iShares GSCI Commodity-Indexed Trust ETF (GSG), 0.75%AGRIBUSINESSMarket Vectors Global Agribusiness ETF (NYSEArca:MOO - News), 0.55%Claymore/Beacon Global Timber Index (NYSEArca:CUT - News), 0.70%WATERPowerShares Water Resources (NYSEArca:PHO - News), 0.64%PowerShares Global Water (NYSEArac:PIO), 0.75%Claymore S&P Global Water (NYSEArca:CGW - News), 0.70%First Trust ISE WATER INDEX (NYSEArca: FIW - News), 0.60%TIMBERiShares S&P Global Timber & Forestry Index (NasdaqGM:WOOD - News), 0.48%SHORT/LEVERAGEProShares Ultra DJ-AIG Commodity ETF (NYSEArca:UCD - News), 0.95%ProShares UltraShort DJ-AIG Commodity ETF (NYSEArca:CMD - News), 0.95%SPECIALIZED ETNsiPath DJ-UBS Softs TR Subindex ETN (NYSEArca:JJS - News), 0.75%iPath DJ-UBS Sugar TR Sub-Index ETN (NYSEArca:SGG - News), 0.75%iPath DJ-UBS Coffee TR Sub-Index ETN (NYSEArca:JO - News), 0.75%iPath DJ-UBS Cotton TR Sub-Index ETN (NYSEArca:BAL - News), 0.75%iPath DJ-UBS Cocoa TR Sub-Index ETN (NYSEArca:NIB - News), 0.75%iPath DJ-UBS Livestock TR Sub-Index ETN (NYSEArca:COW - News), 0.75%ELEMENTS MLCX Grains Index TR ETN (NYSEArca:GRU - News), 0.75%UBS E-TRACS CMCI Food TR ETN (NYSEArca:FUD - News), 0.65%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.
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