Is this Food Inflation Hedge Worth Its Starch?

We're continuing to ramp up our ETF coverage.

We recently added our  188th fund to coverage and provide valuation-centric analysis of  several hundred other stock ETFs. (We're able to estimate a stock ETF's intrinsic worth by rolling up the fair value estimates that our stock analysts place on its underlying holdings; for an overview of this approach, click here.) Taken together, we analyze ETFs representing more than 90% of the U.S. ETF industry's assets and trading volume.

While we're excited about our unique, valuation-centric approach to analyzing stock ETFs, it's worth noting that we cover a great many bond, currency, and commodity ETFs. Some of these funds have been very hot, posting huge gains amid the commodities boom and attracting investors in droves.

Predictably, ETF and ETN providers have launched a bevy of commodity and currency funds in recent months--41 of the 85 ETFs or ETNs launched thus far in 2008 have a commodities or currency focus. In particular, we've seen a number of agricultural commodities ETFs and ETNs come to market of late. These are funds that invest in futures contracts tied to commodities like corn, wheat, soybeans, and sugar.

The question, of course, is whether agricultural commodities funds like these make sense in a portfolio. To address that question, we recently added PowerShares DB Agriculture (DBA) to coverage. That fund, which tracks an index that invests equally in corn, sugar, wheat, and soybeans futures contracts, earns the distinction of being the oldest (January 2007 inception), largest ($2.6 billion in assets as of April 30, 2008), and most heavily traded (3.1 million share three-month average trading volume) agricultural commodities ETF in existence. But is it worth owning?

My colleague Emiko Kurotsu set off to answer that question in her analysis of the fund, which follows below. It's worth noting that we'll be adding a number of other commodities and currency ETFs to coverage in the weeks ahead. Premium subscribers to Morningstar.com should keep an eye on  our coverage list for further details. (If you're not already a Premium member, a free 14-day trial is worth checking out.)

 PowerShare DB Agriculture DBA
by Emiko Kurotsu

Thesis 05-12-08

PowerShares DB Agriculture isn't our first pick for commodities exposure.

This exchange-traded fund tracks the Deutsche Bank Liquid Commodity Index-Optimum Yield Agriculture Excess Return, which invests equally in the futures contracts of four key agricultural commodities--soy, wheat, sugar, and corn--and rebalances annually.

Agricultural commodities are normally relegated to a supporting role in the popular diversified commodities indexes. For instance, ag commodities recently made up just over one third of the Dow Jones/AIG Commodity Index and figure even less prominently in the production-weighted S&P Goldman Sachs Commodity Index, where they recently accounted for just 12% of the benchmark.

Nevertheless, agricultural commodities have come to the fore in recent years for a few reasons. First, the subsector has posted standout returns, as demand for foodstuffs and biofuel inputs have handily outstripped supply. Second, as ag commodity prices and, thus, food inflation has risen, investors have taken notice of the subsector anew, propelling interest in pure-play agricultural commodity products like this fund.

That's not reason enough to invest here, though. True, the fund's narrow mandate might appeal to investors seeking a hedge against food inflation or simply to wager on the future direction agriculture commodity prices take--up or down. But it comes at a price--this fund is much more volatile than others tracking better-diversified commodities indexes.

Given that commodities are good diversifiers thanks to their low correlation with other asset classes, we think that commodities funds can certainly play a role in a portfolio. We're just not convinced that most investors--save for the small subset described previously--need anything as specialized as this ETF. Instead, for those seeking commodities exposure, we think it's more prudent to invest in a fund that tracks a broad commodities index, like the Dow Jones/AIG benchmark. (It's worth noting that the various commodities subsectors aren't strongly correlated with each other, explaining why commodities baskets are less volatile than more narrowly focused offerings like this one.)

And even if you are hellbent on investing in agricultural commodities, we think it's worth considering alternatives to this ETF for a few reasons. First, because of the fund's size, it was recently bumping up against regulatory limits capping its positions in the corn and wheat markets. As such, it has had to utilize futures contracts other than those specified by its benchmark, a tack that could cause its returns to deviate from the benchmark's. Second, you can invest in a slightly more varied set of agricultural commodities via iPath Dow Jones/AIG Agriculture Total Return ETN (JJA), which owns everything this ETF does, plus soybean oil, coffee, and cotton.

Portfolio Construction
This fund tracks the Deutsche Bank Liquid Commodity Index-Optimum Yield Excess Return, a benchmark that invests equally in futures contracts for corn, wheat, soy beans, and sugar, and collateralizes its positions with 3-month U.S. Treasury securities. Thus, the fund's total returns equal the performance of its underlying futures contracts, in addition to the interest earned from its short-term securities. The benchmark rebalances annually.

Recently, the fund has had to buy futures contracts other than those specified by its index because it has been bumping up against regulations limiting the size of its position in the corn and wheat markets. While the fund is attempting to buy contracts and commodities that are proxies for the contracts and commodities stipulated by the benchmark, this substitution could cause the fund's returns to deviate from its benchmark index and dilute the purity of your exposure to the fund's stated holdings.

Fees
This fund imposes a 0.75% yearly management fee. The fund's expense ratio is about average compared with other agriculture commodities-based ETFs. The cheapest agricultural commodities ETF is E-Tracs UBS Bloomberg CMCI Agricultural Total return ETN, which costs 0.65%.

Bulls Say

• The fund's 0.75% expense ratio is inexpensive in absolute terms.
• This ETF offers concentrated exposure to four basic foodstuffs: soy, sugar, corn, and wheat. Thus, it could serve as a useful hedge against food inflation.
• The fund is the oldest, largest, and most heavily traded agricultural commodities ETF in existence, traits that traders are likely to prize

Bears Say

• This fund recently began to exceed regulatory limits capping its exposure to certain agricultural commodities. Consequently, it has been forced to substitute certain futures contracts for those stipulated by its benchmark index. This could cause the fund's returns to deviate from the index's.
• Though good diversifiers and useful inflation hedges, commodities can be volatile unto themselves. This ETF ups the ante by limiting its focus to a single commodities subsector--agricultural commodities.
• This fund isn't the cheapest agriculture commodity option available. E-Tracs UBS Bloomberg CMCI Agriculture Total Return ETN costs 0.65% and is somewhat better diversified than this fund.
• Like most other commodity funds, this ETF is subject to the 60/40 rule, subject to which 60% of all gains are taxed at lower long-term capital gains tax rates and 40% at more-punitive short-term rates, irrespective of an investor's holding period. For the time being, ETNs enjoy much more favorable tax treatment (15% long-term capital gains regardless of holding period).

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, Claymore, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.