As a financial advisor in this country's farming epicenter, Adam Harter is all too familiar with the ups and downs endured by clients who make a living from wheat, corn and other agricultural products. "With the price of food going up so much in the last year, you'd think the farmers here would be getting rich," says the Anderson, Ind., president of Financial Enhancement Group. "But their production costs have gone up so much that it's not as much as a boom to them as you'd think." Still, he says that his farming clients, most of them in their fifties and sixties, have learned to live with the uncertainties of weather, demand and financial markets that drive the prices of their products.
Like the farmers Harter advises, investors must also be willing to endure the vagaries and volatility of the commodities markets if they want to profit from the recent "agflation"-a phenomenon that has led to smaller packaging and supermarket sticker shock in the U.S. (not to mention rioting in some foreign countries). Until recently, investors had to navigate complex financial instruments tied to the prices of soybeans, corn and other grains to gain exposure to the commodity subset.
While commodity prices remain as unpredictable as the weather, betting on them got a lot easier about 18 months ago when PowerShares introduced the DB Agriculture Fund ETF. Since then, a number of other firms such as Van Eck, Barclays and Lehman Brothers have cooked up their own ETF products designed to tap the fertile agriboom.
Matthew McCall, a financial advisor at Penn Financial Group in Ridgewood, N.J., who specializes in ETF portfolios, says the timing for easy access to agricultural commodity investments couldn't be better. Because he sees a critical shift in asset class leadership, he has devoted as much as 20% of his client portfolios to commodities, and as much as one-quarter of that allocation goes to pure ag ETFs.
While he acknowledges the potential volatility of these investments, he believes they are great long-term plays because of increasing demand worldwide. Because some of the newer entrants are thinly traded and have liquidity issues, he generally sticks to more established names such as the PowerShares ETF (DBA), the Elements ETN-Rogers Agriculture Trust (RJA) and the iPath Dow Jones AIG Livestock Total (COW), a pure play in farm animals.
New products such as these carry a number of risks. The Rogers Trust and many of the new agriculture products are exchange-traded notes, or ETNs, which are debt instruments that trade like a stock and mimic the movement of a particular index. The structure exposes them to the credit risk of the issuer, as well as the fluctuation of the underlying commodity prices.
The tax treatment of ETNs, as well as ETFs, bears watching. Under an IRS ruling issued in December 2007, currency ETNs are now treated as debt for federal tax purposes and receive less-favorable tax treatment than they did before. Although the ruling does not extend to commodity ETNs at this point, some people are concerned that a ruling on exchange-traded notes could be the next step. As for commodity ETFs, some of their gains are treated for tax purposes as long term and some are treated as short term, regardless of the investor's holding period.
To avoid potential tax complications, McCall prefers putting ETNs in a tax-deferred account. But taxes are not the focus here, he stresses. "I believe commodity investments are going to outperform most of the stock market, so it makes sense to possibly give up in taxes what I believe a client is likely to gain in returns."
Bubble Or Opportunity?
Given the recent run-up in the price of grain-based products and the long-term demographic trends, McCall says his heavy emphasis on the sector is a forward-thinking strategy. According to a recent report from the U.S. Department of Agriculture, world market prices for major food commodities such as grains and vegetable oils have driven food commodity prices more than 60% higher over the last two years.
Among the trends contributing to food inflation are the rise of ethanol and other biofuels; increased demand for grain feeds necessary to produce meat; weather-related disasters that wipe out or reduce crop production; and finally, the weak dollar, which prompts foreign countries to import U.S. grains. Meanwhile over the last couple of years, hedge funds and index funds have held an increasingly large percentage of open interest in the futures market for agricultural commodities, creating more speculation and greater uncertainty about pricing.