Harsh weather is disrupting food supply around the world just as a rising middle class in emerging markets and a burgeoning biofuels industry put extra demand on farmers.
In this turmoil, investors see opportunity. Futures contracts for coffee, sugar, corn and wheat have rocketed more than 50 per cent since last summer, and financial institutions are responding with new funds that offer ways to bet on rising food prices.
"There are plenty of products trying to take advantage of this hot trend," says John Gabriel, an exchange-traded fund strategist with Morningstar Inc. in Chicago.
Numerous exchange-traded funds (ETFs) and exchange-traded notes (ETNs) now focus on agriculture. Some buy the stocks of companies that produce food or make equipment for the farming industry. Others purchase futures contracts on agricultural commodities.
An example of the first approach is Claymore Investments Inc.'s Global Agriculture ETF, which invests in stocks of companies in the agricultural sector, including Deere & Co. and Monsanto Co.
An example of the second approach is Bank of Montreal's BMO Agriculture Commodities Index ETF, which focuses entirely on food commodities. The holdings include futures contracts for wheat, sugar, corn, soybeans cotton, coffee and cocoa.
Investors who want to bet on specific commodities can do so through a variety of ETNs. Barclays Bank PLC's iPath ETNs let you gamble on the direction of coffee, cotton, cocoa or sugar prices.
There are even ways to invest if you think the agriculture boom is due to go bust. Invesco Ltd.'s PowerShares sells an agriculture ETN that lets you go short on the sector or even double up on the bet.
ETFs vs ETNs
Before investing, investors should learn the difference between ETFs and ETNs.
ETNs are actually a type of debt. The issuer of a commodity ETN guarantees results that are linked to the performance of a specified commodity index. Since the payoff depends upon the solvency of the issuer, an ETN's value can drop if the issuer's credit rating is cut. ETNs can be held to maturity or bought and sold in the secondary market.
In contrast, ETFs are securities that operate something like an mutual fund, but are traded like stocks on an exchange.
ETFs that focus on agricultural commodities provide investors with exposure to food prices, but just because the spot market price for coffee or cocoa may be soaring doesn't necessarily mean the ETF will rise, Mr. Gabriel says. "Don't buy any of these products if that concept doesn't make sense," he advises.
ETFs that invest in commodities generate returns based on three distinct components. To start, there are the spot prices of the commodities (in other words, the price you would pay for immediate delivery of them). There is also the performance of money market instruments or stocks. Finally, there is something called "roll yield."
To understand how this works, start with the fact that the ETF pays for the futures contracts it holds based on their daily gains or losses rather than with an upfront lump sum. That allows ETFs to invest a lot of their assets in stocks or money market products such as T-bills. The money generated by those investments produces part of your return.
The roll yield occurs as a futures contract gets closer to its delivery date. The price of the futures contract must converge with the spot market price.
Backwardation and Contango
When the price of a futures contract is below the expected future spot price, traders describe the situation as backwardation, which creates positive roll yield as the price of the futures contract rises or "rolls" to meet the spot price. But when the price of a futures contract is above the expected future spot price, the situation is called contango. That causes a negative roll yield, as the futures prices declines to meet the spot price.
In general, backwardation works in favour of investors in futures contracts, while contango hurts them.
"Commodity ETFs are not for everybody. You need that extra amount of risk tolerance," adds Adrian Mastracci, portfolio manager with KCM Wealth Management Inc. in Vancouver. He recommends holding a diverse group of commodities - such as energy, agriculture and metals - and keeping them to 10 per cent or less of an investment portfolio.
One ETF that Mr. Gabriel favours is the United States Commodity Index Fund, up 40 per cent since it launched last August. The fund attempts to minimize the harmful effects of contango by buying commodities in backwardation. Its composition changes from month to month based on a complicated mathematical model. Contracts for 14 of 27 eligible commodities are held each month, with at least one commodity from each sector: energy, metals and agriculture.
"Investors should know that most commodities are experiencing contango at the moment," says Paul Vaillancourt, chief investment officer at Canadian Wealth Management in Calgary.
Agricultural commodities, however, remain in the opposite type of market, backwardation, which is more desirable for traders who are buying futures contracts. But conditions could swing quickly for agricultural commodities, as they have for hard commodities, and investors in funds comprised of agriculture futures could suddenly find themselves in a contango market, he says.
Mr. Vaillancourt believes the simplest way to get exposure to the global agriculture sector is to invest in companies that sell products to farmers, including Deere & Co., Agrium Inc. and Caterpillar Inc.
Playing the field
ETFs and ETNs offer numerous ways to invest in the booming agriculture sector. (Percentage returns for last 12 months ended Feb. 14)
Global Agriculture ETF
+ 33 %
Broad food commodity futures
BMO Agriculture Commodities Index ETF
Single food commodity futures
iPath Dow Jones-UBS Cocoa Subindex Total Return
(Similar iPath products are sold for coffee, cotton and sugar)
Short food commodity futures
PowerShares DB Agriculture Short ETN
Extra-leveraged food commodity fund
PowerShares DB Agriculture Double Long ETN