Using ETFs to invest in soft commodities

In the first article, last week, I covered general aspects relating to investment in the global agricultural sector and indicated that future articles would focus in more detail on the various options available to private investors based in the UK.


These options range from broadly based collective funds at one end of the spectrum to direct investment in farms at the other.


Collective funds include closed ended investment trusts, open ended unitised trusts and a fast expanding list of exchange traded funds that are low cost passively managed funds whose underlying portfolios are closely linked to specific indices. I shall now start off this series of specific profiles with an outline of the opportunities for investment exposure to agriculture and soft commodities using exchange traded funds (ETFs).

Advantages and disadvantages of using the ETF route


Over the past decade, ETFs have become extremely popular with a large number of professional and private investors who wish to gain exposure to particular market sectors through clearly defined low cost funds that are openly traded on leading stock exchanges, such as the London Stock Exchange.


Costs are low because the funds are passively managed with the objective of achieving as close a correlation with the chosen underlying index as possible.


In fact, reduced cost is one of the major advantages claimed by ETF managers. They use the term Total Expense Ratio (TER) to differentiate their products from the charges levied by unit and mutual fund providers. Typically, ETF managers will charge no more than 0.5% per year for equity based ETFs and less than 0.25% for ETF bond funds compared to average annual charges of more than 1.5% and 1% for equity and bond mutual funds.


Unlike retail based unitised funds that operate on a regime of daily fixed pricing, usually with a significant spread of around 5% between bid and offer, the prices of ETFs are determined live by the market.
Apart from the clear cost advantage of this medium, the basic structure of the ETF is designed to enable investors to diversify portfolio risk by choosing from within a massive range of investment themes. There are reported to be currently over 1,600 ETFs traded on the LSE market.
The main disadvantage of the ETF as a medium for investment is of course the basic fact that the funds are all designed to mirror the chosen underlying index so by definition outperformance is impossible and in reality the most that can be expected is marginal under performance after deduction of the manager's fees although these are admittedly very low. Indeed, the marketing charts supplied by most ETF managers make a point of illustrating how closely their funds relate to their benchmark index.
A further disadvantage is that most ETFs do not pay out any regular income in the form of dividends but roll up net income in the same way that the capital versions of mutual funds do.
Thus, in short, ETFs are an easily traded low cost way of diversifying portfolios and focusing on specific investment themes but the product range is not designed to achieve superior individual returns.


Using exchange traded funds to target the agriculture sector


Over the past decade the availability of ETFs has risen in both number and breadth of cover as the main providers such as BlackRock iShares, Invesco PowerShares, Deutsche Bank DB Xtrackers, and ETF Securities have launched an ever increasing number of specialist index tracking funds.
Although the main focus of most of the ETFs has been on financial and global indices and the hard commodities, there are a few specialist funds that cover the agriculture and soft commodities sectors. In addition to generalised funds that replicate the broad indices, there are also a number of highly focused commodity funds that target specific commodities such as wheat, soya, sugar and coffee and these are often further sub-divided into spot, future and leveraged versions.
As success with specific single commodity funds necessitates that investors possess a detailed understanding of the relevant underlying markets and are able to follow closely the forces influencing them, I shall exclude analysis of them at this stage but rather focus on the opportunities using ETFs covering broad agriculture and agri business.
The db X-trackers DBLCI (Liquid Commodity Index) Optimum Yield Balanced ETF


Code: XDBD.L Recent price: $33.3 TER: 0.55%


I shall not dwell on this broad spectrum ETF as it covers a wide range of commodities apart from the traditional "softs".
As at the end of July, gold accounted for 15% of the fund total with aluminium, copper, zinc and silver making up a further 23% and oil and gas some 26%. Nonetheless, the main globally traded crops of wheat, maize, soyabeans and sugar accounted for a meaningful 28% of the total funds.
Since launch in July 2007 this broad based commodity fund had, by 30th July 2010, appreciated by 177%. According to Deutsche Bank records the fund recorded a gain of 6.4% in the year to end July 2010, considerably less than the 14% advance of the FTSE 100 equity index over the same period


However, in calendar 2009 the fund returned 27% against a 21% gain in the main All Share index.

The ETF Securities Broad Agriculture Fund and the Agri Business Funds


ETF Securities Agriculture Fund


Code: AGAP.L (GBP) Recent Price: 429p TER:0.65%


Code: AiGA.L (US$) Recent Price: $6.63 TER:0.49%


The ETF Securities managers have created a large number of specialised funds related to soft commodities that focus on single crops such as wheat, soya, coffee, cocoa and sugar and then sub-divided these into separate entities covering future, short and leveraged positions. Thus any investor who believes that the current high price of wheat is overdone might wish to choose the short wheat fund but still take a position in forward wheat if believing that future prices are likely to harden.


However, an initial foray into the wider soft commodities market will probably be better served through a broader fund such as the ETF Securities Agriculture Fund.


Strictly speaking this is really a commodities based vehicle that is designed to track the DJ-UBS Agriculture Sub-index. The underlying assets are effectively futures contracts on coffee, corn, cotton, soybeans, soybean oil, sugar and wheat. It reflects the return of the movements in futures prices of each commodity, quoted in US dollars.

This fund recently reported that 50% of total value was represented by soyabeans (26%) and maize ( 24%) with wheat (15%) and cotton, sugar, coffee and soyabean oil each varying between 7% and 10%. The overall product weighting is therefore very closely allied to the US agricultural sector. This is not necessarily a disadvantage but mirrors the global importance of the United States as a key farming nation and one of the largest exporters of agricultural commodities.
It is probably worth noting that in recent years the price performance of soft commodities has tended to do better during periods of economic difficulty exhibiting a negative correlation to global equity indices and providing an attractive option for investors seeking portfolio diversification as illustrated in the chart supplied by ETF Securities.
Source: ETF Securities

ETF Securities Agri Business Fund


Code: AGRP (GBP) Recent Price: 2,760p TER:0.65%


Code: AGRI (USD) Recent Price: $42.6 TER:0.65%


This fund is designed to follow the S-Net ITG Global Agriculture Index that is built to mirror the share price performance of the largest listed companies that are closely linked to global agriculture. The agricultural sub sectors covered include: a) seeds, chemicals and fertilizers, b) equipment and irrigation, c) agricultural commodities and d) livestock production.


As there are virtually no really large global players operating directly in the production end of farming, the Agri Business Fund is principally formed from stakes in those businesses serving the international farm community rather than actually producing crops and other farm products.
However, the portfolio does include a number of well established agriculturally based traders such as Singapore-based Wilmar International and US-based Bunge and Archer Daniels Midland, the latter two being huge operators in trading grains and other key soft commodities.


In fact, manufacturers and suppliers of agricultural chemicals and fertilisers comprised 61% of the underlying index as at end June 2010 with equipment and construction companies contributing a further 10% of the basic index
Because of this fund's close relationship to large cap listed businesses it is hardly surprising that its performance has been more closely correlated with broad movements in the stock market than the commodity indices and so is effectively a less useful defensive play in times of financial market weakness.
However, as a longer term play related to the ultimate recovery in agricultural sector terms of trade this fund could be worth following as it has significantly outperformed the leading US market indices over the past five years.


Invesco PowerShares Global Agriculture Portfolio ETF

Code: PAGG.L Recent price: $25.6 TER: 0.75%
This fund is very similar in composition to the ETF Agri Business fund as it is based on the NASDAQ OMX Global Agriculture index and largely covers the business sectors of the agricultural supply industry.
Major holdings in Wilmar International, Syngenta, Monsanto, Potash Corp, Mosaic and Archer Daniels Midland account for over 42% of the total portfolio compared to 48% for the ETF fund. According to the managers' most recent factsheet the fund's underlying investment portfolio is more widely spread geographically than the ETF Securities Agri Business Fund but for this minor advantage there is also a marginally higher management charge of 0.75%.


Conclusion

Bulls of the underlying agricultural scene promote the importance of key drivers forcing up soft commodity prices in the longer term.

These include gradually reducing availability of productive arable land, growing world population, rising incomes in the huge emerging BRIC nations leading to diets featuring a higher proportion of meat replacing direct consumption of grains and also the diversion of annual crop production from feedstuffs to biofuels. Add in the uncertain effects of climatic disasters such as floods and droughts and the equation would appear clearcut.


However, as mentioned in the first article in this series, there is still massive potential for further improvements in technology. It is always possible that there will be a second stage to the highly successful green revolution of the 1970s and 80s with genetic modification capable of generating substantial improvements in yields while also reducing demand for fertilizers and improving disease resistance.


On balance, I believe that technological advances will have a struggle to generate enough additional supply to meet the anticipated rise in effective global demand for soft commodities and thus I still expect the terms of trade to improve in agriculture's favour over the coming years. In this scenario I can see ETF funds playing a useful part in well balanced growth portfolios.