Agricultural Commodities in the Spotlight

Over the past month, prices of agricultural commodities including corn, soybeans, and wheat have spiked in response to poor growing conditions in North America and Europe. While the fundamental story may play out over the long term, this highlights the pronounced impact of weather conditions on the agricultural complex. The Bloomberg Agriculture Subindex gained about 14% in the trailing one-month period through July 15. Longer-term performance, however, has been very uninspiring, as the index has posted annualized losses of more than 13% over the past three years.

For those looking at potential investments in the category, there are some offsetting forces at play that are worth considering. The bullish thesis is based on a growing global population and a finite amount of arable land for farming. In general, more mouths to feed means greater demand for grains and other agricultural commodities. That said, greater agricultural productivity has led to bigger crop yields, which has so far kept a lid on agricultural commodity prices. Unpredictable and volatile weather is the major wildcard in the equation, complicating the supply-demand dynamic even further.

Given the attention the space has garnered recently as prices surged, we highlight the largest agricultural commodities exchange-traded product,

Suitability PowerShares DB Agriculture ETF, which employs a dynamic approach to investing in agricultural commodity futures contracts, can be viewed as a satellite holding for use by those who have an understanding of how futures markets operate (and, in turn, affect the performance of the fund) and who hold a positive outlook for the prices of agricultural commodities. The fund offers exposure to a basket of 10 agricultural commodity futures, ranging from corn and soybeans to live cattle and lean hogs to coffee and sugar.

This futures-based fund follows a proprietary rules-based indexing strategy designed to achieve the best roll yield possible. While first-generation futures-based commodity exchange-traded funds systematically roll near-month futures contracts forward as they near expiration, DBA employs what is termed the "Optimum Yield Roll" process. This strategy was developed by Deutsche Bank Commodity Services LLC and analyzes futures contracts that mature over the next 13 months. The aim is to maximize the positive roll yield when a particular futures curve is in backwardation (futures contracts trading below the spot price) and minimize the negative roll yield when the futures curve is in contango (futures contracts trading above the spot price).

Most investors will find limited use for this narrowly focused product. While commodities can be an important slice of a well-diversified portfolio, many investors can gain adequate exposure to agricultural commodities through a single broad-basket commodities fund, such as

Despite low returns during the past decade, commodities have historically provided a good hedge against unexpected inflation. Commodities have also been shown to offer diversification benefits thanks to their historically low correlations with traditional asset classes. For example, during the past five years, DBA has been 43% correlated with the S&P 500, and its correlation was negative 3% with the Barclays U.S. Aggregate Bond Index.

Fundamental View Thanks to a growing global population, evolving diets in the emerging world's middle class, and a limited supply of arable land for farming, agricultural commodities have piqued the interest of many investors. Moreover, like all commodities, they could potentially serve as an effective hedge against future inflation. Some investors may even point to relatively new sources of demand coming from the biofuels industry as further rationale for a positive outlook for the subsector.

While there is certainly merit to the investment thesis outlined above, there is much more to consider. Most important, perhaps, is the long-term theme of increasing farming productivity driven by the use of fertilizers and genetically modified seeds. Another wild card for the agricultural complex revolves around weather patterns. Just as optimal weather conditions in key farming geographies can help bolster crop yields, weather disruptions can also decimate supply. Potential investors must be cognizant of the unpredictable nature of weather and its undeniable impact on the volatility of agricultural commodity prices.

The collapse in oil prices in the back-half of 2014 will also likely have an impact on the agricultural sector. For example, corn and oil prices are related through ethanol. The sharp decline in the price of oil has weighed on ethanol prices, so much so that it has become unprofitable for ethanol producers to maintain production at current prices. As the spread between corn and ethanol prices has fallen below break-even, it's likely that ethanol production will see sharp reductions in 2015. Reducing this key source of demand will therefore lower demand for corn and drive prices lower.

Pressure on corn prices can also cause ripple effects across grains. If corn prices fall, then farmers are likely to dedicate more acreage to grains that can fetch higher prices. The resulting increase in supply across those grains can therefore keep a lid on prices for other grains.

Of course, oil is also a key input for grain production, in general. So, lower oil prices can help improve profit margins in the near term. There are many moving parts in the agricultural complex, which can make navigating it a challenge for uninitiated investors. Adding in the wild card of unpredictable weather patterns makes it an even greater challenge yet. Unfortunately, there's much more to the story than a growing population and limited available farmland.

As noted, DBA's dynamic futures rolling strategy aims to mitigate contango-related losses by selectively stretching further out on the futures curve. This is because contango tends to be steepest at the short end of the futures curve. By extending its maturities in contango markets, DBA tries to minimize negative roll yield. Investors should keep in mind that it cannot completely avoid the negative impact. Similarly, DBA will try to target futures contracts with shorter maturities when dealing in backwardated markets in an effort to maximize the tailwind from the positive roll yield.

In the end, the basis risk that causes spot and futures prices to decouple is unavoidable. Moreover, frequent shifts between contango and backwardation within agricultural commodities pose a considerable challenge to DBA's patented "Optimum Yield" strategy.

Portfolio Construction This fund tracks the DBIQ Diversified Agriculture Index Excess Return. As of Feb. 23, 2015, DB Commodity Services LLC ceased managing the fund. Deutsche Bank Securities Inc., however, remains as the fund's index sponsor and marketing agent. The managing owner of the fund is now Invesco PowerShares Capital Management LLC. The index is a benchmark that tracks futures contracts prices of feeder cattle, cocoa, coffee, corn, cotton, lean hogs, live cattle, soybeans, sugar, and wheat, rebalanced to weightings of 4.2%, 11.1%, 11.1%, 12.5%, 2.8%, 8.3%, 12.5%, 12.5%, 12.5%, and 12.5%, respectively, on an annual basis. Contract selection is adjusted based on the shape of the yield curve at the time of purchase. Rather than simply holding contracts until two weeks before expiration, DBA's methodology distinguishes itself by allowing for the ability to dump contracts at any point in time. This exchange-traded product is structured as a limited partnership, which has special tax implications.

We recommend consulting your tax professional before investing. Take note of these tax points: (1) Gains/losses in the fund will be taxed each year, 60% at long-term capital gains rates and 40% at short-term rates, and open contracts at year-end will be marked to market and subject to 60/40 treatment as well; (2) investors will be liable for their prorated share of this tax liability, which will be provided in a K-1 statement; (3) the fund does not distribute realized capital gains, so investors will have to pay this tax obligation out of pocket; and (4) investors must also recognize interest income, taxable at ordinary rates, from the cash collateral, although this will be negligible in the near term given current rates.

DBA imposes a 0.85% yearly management fee, plus an estimated brokerage fee of 0.04%. This is slightly higher than many commodity ETPs but still within reason for a fund with such a specialized and narrow focus. That said, the fund's estimated holding cost, which includes the impact of tracking error, clocks in at 1.38%. Over the trailing one-, three-, and five-year periods through July 15, the fund trailed its benchmark by 1.37%, 1.20%, and 1.19%, respectively. When considering fees, investors should also take note of the special tax considerations associated with the fund's futures positions held within its limited partnership structure.

Alternatives

A close alternative to DBA is

Investors looking for exposure to the agriculture complex but who are turned off by the complexities of investing in commodity futures can also consider

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