Harvesting profits

The drought that has devastated Russia’s wheat harvest has brought misery to thousands, but the sharp rise in prices has meant bumper returns for investors in the agriculture sector. Nick Sudbury reports

The worst drought in Russia for a century looks like it could reduce the country’s massive grain crop by around a quarter. In order to conserve local supplies, the Russian government has put in place an export ban that will run until the end of the year.

Russia is a major exporter of grain and the disruption to the world’s supply has had a sharp impact on prices. US wheat futures are up more than 80% since mid-June, the fastest rally in nearly 40 years. Other crops including barley, corn and rapeseed have also jumped higher. 

The main beneficiaries of all this have been investors in the agriculture sector. In the last three months many of these products have recorded high double-digit returns that have more than made up for a relatively slow start to the year. 

Star performers 

The top performing ETF in the sector over the last 12 months was the US-listed Market Vectors Agribusiness fund, with a return of 26.43%. It also has an impressive longer term track record with a three-year gain of 44.66%. 

The Market Vectors ETF tracks the DAX Global Agribusiness index, which measures the performance of companies from across the world that derive at least 50% of their revenue from agriculture. It currently has 44 holdings with some of the best known being Monsanto, Potash Corp and Del Monte Foods. 

Another ETF with a strong one-year record is the PowerShares Global Agriculture fund, which is listed in both the US and Switzerland. This tracks a similar equity-based index of agriculture stocks. 

Tim Mitchell, head of specialist funds at Invesco Perpetual, the parent company of PowerShares, says anything that invests in equities is affected by a lot of different factors and does not represent a pure commodity play.  

“Corporates tend to borrow which means they provide something of a geared exposure to the underlying commodities. Their share prices can also be affected by bid premiums as we have seen recently with Potash Corp.” 

Diversified commodity exposure

Many of the products in the agriculture sector are structured as exchange-traded commodities (ETCs), the majority of which are issued by ETF Securities. Their top performer last year was the ETFS Leveraged Agri DJ-UBSCI ETC, which aims to produce a daily return of double the movement in the underlying index. The London-listed, dollar denominated version was up 28.18%, which was slightly ahead of the euro-based equivalent that trades in Germany. 

The DJ-UBS Agriculture Sub-index underlying these ETCs provides exposure to a number of different commodity futures contracts. At present the largest weightings are: soybeans at 24.6%, corn at 23.6% and wheat at 18.3%. The balance is made up of coffee, soybean oil, cotton and sugar. 

Apart from the strong returns, another good reason for investing in agriculture is the diversifying effect it has on a portfolio. According to Barclays, the Dow Jones-UBS Agriculture Sub-index has a correlation of just 0.33 with the S&P 500 and 0.24 with a representative bond index. 

Pure commodity play

ETF Securities also has a whole range of single commodity ETCs. These ETC returns can experience a greater degree of volatility than investing in a more diversified range of commodities, but they can also have more upside potential. ETFS Cotton for example has risen almost 42% in the last 12 months partly in response to the disruption in supply caused by floods in Pakistan. 

Daniel Wills, senior analyst at ETF Securities, says the predominant driver of returns over time is the underlying spot price of the commodity, which is determined by supply and demand.

“A further consideration for investors is the shape of the futures curve. In order to maintain a constant exposure the contracts have to be periodically rolled over. Where the futures curve is sloping upwards this entails paying more, which will detract from the return.”  

The firm’s ETCs are undated, secured debt securities that are backed by matching commodity contracts, issued by a counterparty. The counterparty risk associated with such commodity contracts is fully covered by the posting of collateral by the counterparty into a separate collateral account with BNY Mellon.  

“Each day a pool of collateral is set aside that can be called upon should the commodity counterparty go under. In the worst case scenario an investor would only be exposed to the intraday movement,” explains Wills. 

These products were not always structured like this. Back in 2008 they were not typically collateralised, which meant that investors took on the credit risk of the commodity counterparty. In many cases this was the insurer AIG, so when the company nearly collapsed the associated ETCs had to be temporarily suspended from trading. 

ETNs

Credit risk is more of an issue when investing in Exchange Traded Notes (ETNs). One example is the PowerShares DB Agriculture Long ETN, which provides exposure to the most liquid agricultural commodity futures contracts such as corn, wheat, soybean and sugar. 

PowerShares also manages a double long, short and double short equivalent. These ETNs are senior unsecured debt obligations of Deutsche Bank, with investors exposed to the full credit risk. In the event of the bank running into problems there would be no underlying assets for the holders of these notes to call on.  

Another set of products with a decent performance record in this area is the iPath range of ETNs issued by Barclays Bank. Examples include the iPath DJ-UBS Agriculture Total Return Sub-Index ETN and the S&P GSCI Agriculture Index Total Return ETN. These both have a 30-year maturity but can be bought and sold whenever the relevant exchange is open for business.

Jigna Gibb, director of the commodity investor structuring team at Barclays Capital, says that ETNs are designed to provide exposure to difficult to access asset classes like commodities. “An ETN is a very simple and fully transparent product with a single fixed fee.” 

The advantage of the ETN approach is that it offers perfect tracking, before fees, of the underlying indices. Alternative products such as ETFs and ETCs may not fully replicate the performance of their benchmarks due to swap fees and collateral costs.

The iPath ETNs are senior, unsecured, unsubordinated, callable debt securities issued by Barclays Bank, linked to the performance of a market index. This means that investors are exposed to the full credit risk of the bank. 

“Bank credit risk was a big concern for investors back in 2008, but in the last 18 months this risk has subsided and we have seen a return to bank-issued products,” says Gibb. 

Moody’s currently assesses the credit rating of Barclays as Aa3, whereas S&P put it at AA-. These both suggest that the credit risk associated with iPath ETNs is very low.