Over the last few years, food price inflation has become a hot-button issue around the world. This comes as little surprise, given sustained price increases across the broad commodities space and the far reaching geopolitical implications it has already posed.
This article will discuss a number of the drivers behind food price inflation, its repercussions, and a selection of ETFs that investors may tap to capitalize upon continued volatility in the space.
Fundamental Drivers
A number of adverse weather-related events have provided stiff positive price pressures on the supply side of the market. For example, a drought in Russia in 2010 consumed significant portions of the nation's wheat harvest, leading Prime Minister Vladimir Putin to bar grain exports altogether. Not surprisingly, the Agricultural Statistics Board (ASB) of the USDA reported last year that wheat prices increased on an inflation-adjusted basis by roughly 34% over two years. Wheat prices were further influenced by similar drivers in the wider FSU region and by fears stemming from severe flooding in Australia, a prominent exporter of wheat.
On par with wheat, corn has been on an unprecedented upward tear. Between 2009 – 2011, the ASB estimates that corn prices rose by roughly 40%, after adjusting for inflation. The price increase is due in no small part to the consistent and drastic increase in corn demand for ethanol. The last decade has seen ethanol demand account for increasingly large percentages of U.S. corn production. In each of the last three years, ethanol production claimed 5% more of overall production than the year prior.
Soybeans have also seen substantial price increases, though they have been less dramatic than the price increases for corn or wheat.
Sustained run-ups in the grains can be seen trickling through to the meats as feed prices increase. The Agricultural Statistics Board pegs inflation-adjusted price increases for cattle and hogs at 42.9% and 42.8% between 2009 to 2011, respectively. Furthermore, population growth will contribute to rising prices in the future. The U.N. projects an 11% global population increase by 2020 and a 20% increase by 2030. Goldman Sachs projects that the global middle class population will expand drastically over the same time frame, to over 3.5 billion by 2030. This growing middle class will demand more meat products, which will continue to fuel price increases.
At Home and Abroad
Given the outsized run-up of agricultural commodity prices, some may be surprised to find that the impact on consumers in the developed world has been relatively muted. For example, in the US only 5% to 7% of per capita income is devoted to food purchases. Further, a significant share of food costs comes from non-commodity-related inputs like packaging and distribution.
In the developing world the story is a bit different. The agricultural industry has grown from the highly local and regionalized markets of the early 20th century into a truly global system. Accordingly, price increases are realized on a global scale. Unlike highly developed nations, the populations of developing nations can spend as much as 40% to 50% of their per capita income on food. There is no question that the lack of a stable food supply and stable prices is a contributing factor in compounding internal political pressures in developing nations.
After examining these statistics, investors may want to consider certain exchange-traded products to capitalize on these trend. Below are a few exchange-traded products to consider:
Broad-Based Agriculture ETF
Market Vectors Agribusiness ETF (MOO) offers global exposure to agricultural by tracking the DAXglobal Agribusiness Index. The index is composed of firms involved in agriproduct and livestock operations, agrichemicals, and production or transport of agricultural equipment and biofuels.
Within the agribusiness industry, market share and scale are vital to success. Price control is exercised by a select few firms, but MOO looks to avoid concentrated exposure by devoting no more than 10% of its assets to any one holding. Nevertheless, MOO is extremely top heavy: the majority of its assets are invested in a select few firms, and roughly 60% of investments are North American holdings. The fund charges a 0.53% total expense ratio, which is roughly in line with other comparable funds.
Investors should note, however, that despite its diverse set of holdings, by virtue of its equity-based structure, MOO exposes investors to equity-specific price pressures and risks. For a closer approximation of the price performance of agricultural commodities one might consider a fund that uses agricultural commodity futures to provide exposure.
Hitting the Meats with COW
IPath Dow Jones-UBS Livestock Subindex Total Return ETN (COW) delivers futures-based exposure, highly focused on two of the most prominent meat contracts: live cattle and lean hogs. The fund levies a 0.75% annual fee, which is reasonable given its relatively niche exposure, but investors should take note of the fund's ETN structure, which is different from the typical ETF structure
There are pros and cons to the ETN structure. Unlike other exchange-traded commodity-focused offerings, ETNs do not maintain a basket of underlying holdings. Rather, they can be considered an unsecured debt obligation, a promissory note that stipulates the return of an underlying index, less an annual fee. The recent financial crisis broke a number of ETN issuers, and while we feel that the banks are in relatively better health than they were in 2008 and 2009, it wouldn't be unreasonable for investors to consider part of their required return a level of compensation for their exposure to the credit default risk of the backing bank. On the up side, however, ETNs provide perfect tracking of its index.
Corn Offerings
Like COW, Teucrium Corn (CORN) offers similarly focused exposure to its target commodity. ETFS Corn ETC (CORN) on the London Stock Exchange also offer investors access to corn markets.
The Teucrium Corn fund procures its exposure through the use of futures contracts. Liquidity and the absence of carrying costs make futures a much more convenient way to gain exposure than direct physical ownership. The catch is that the futures curve--the prices of contracts at progressively distant expiration dates--can take an upward slope (known as contango) or downward slope (known as backwardation). That slope can cause futures and spot returns to decouple, also known as basis risk.
Many of the early futures-based commodity exchange-traded products set contracts at predetermined expiration intervals, leaving them vulnerable to losses when the shape of the futures curve shifted. By spreading its assets across a number of corn futures with different expirations, however, CORN attempts to mitigate the impact of rolling contracts forward in contangoed markets. CORN spreads its assets across three corn futures: the second-to-expire, the third-to-expire, and the following December contract at weights of 35%, 30%, and 35%, respectively. In doing so, the impacts of contango are realized by only roughly a third of the fund's assets at any one time.
While contango-related losses should be tempered to a large degree, there are several considerations to be had before establishing a position here. Investors looking to make a very short-term speculative bet on corn prices would likely do better to hold the front-month futures. The closer a futures contract is to expiration, the more sensitive it will be to movements in the price of the underlying commodity. In spreading its assets along the curve, CORN avoids the outsized effects of contango on the front end of the curve, but also dampens short-term responsiveness to the spot price. With a total expense ratio at 3.5%, the fund also stands as one of the most expensive within the exchange-traded-product space. Nevertheless, CORN is the first corn-focused ETP that provides a pure play exposure to corn prices.
A Dynamic Twist on Broad Agricultural Exposure
Investors looking for an offering that will tap the broad agricultural commodities space can also consider PowerShares DB Agriculture (DBA). Using futures contracts, this fund provides exposure to feeder cattle, cocoa, coffee, corn, cotton, lean hogs, live cattle, soybeans, sugar, and wheat. Weightings for each investment are rebalanced on an annual basis.
Like Teucrium Corn, PowerShares DB Agriculture looks to mitigate the adverse effects of a negative roll yield in contangoed markets in a number of ways. Levels of backwardation and contango are almost certain to vary between the individual commodities-future markets at any point in time. Thus, by maintaining exposure to a set of commodities, DBA diversifies away from an outsized level of contango in any particular market. DBA goes further, however, by employing a dynamic futures strategy.
Using Deutsche Bank's DB Optimum Yield indexing methodology, the fund puts on contracts with expiration dates as far out as 13 months that stand to maximize gains or minimize losses posed by the implied roll yield. Like CORN, DBA can spread its assets along the curve of any particular commodity-futures market, but its quantitatively based methodology also allows it additional flexibility in selecting the best contracts with which to do so. Thus, DBA provides an outlet for investors who want broad agricultural exposure but don't want to have to worry about how the daily dynamics of the futures market are changing.
PowerShares DB Agriculture charges an annual fee of 0.85%, on top of trading-related costs. The estimated brokerage fee projects a total fee of roughly 1% annually, so as with CORN, investors should seriously consider the fund's expenses before making a purchase.
There is a strong case to be made for a continued bullish run of agricultural commodities. Investors holding this view may look to a number of available exchange-traded products to gain exposure, but it is important to understand what type of exposure you are buying. Equity-based funds will introduce non-commodity-related price pressures and futures-based funds do not hold the physical commodity. While the price performance of agricultural commodity futures are tied to movements in the spot markets, they are derivatives and thus only track imperfectly in the short term. These funds will also be impacted by a number of other factors, and investors should not assume that they will always serve as a perfect proxy for the underlying commodity. The drivers for these types of exposures are highly speculative, and investors looking to establish positions here should be aware of these risks and take appropriate precautions.
An original version of this article was published March 2011 on Morningstar.com.
