No soft option for investors

As the world population grows and large numbers – such as in China and Brazil – move out of poverty, demand for food increases.

Since investment in production has been negligible for the past 30 years, as investors focused on urbanisation and technology growth, prices of agricultural commodities have gone up.

According to the UN Food and Agriculture Organization Food Price Index, food stuffs were 36 per cent more expensive in April 2011 than a year earlier.

This blunt number masks a more complicated picture in so-called “soft” commodities – grains and maize rose, while sugar and dairy prices fell and fats and meat were largely unchanged, but the headline number fits the generally bullish nature of commentary on food prices.

“Over the past five or 10 years, we’ve seen declining inventory levels globally, while demand has shifted,” says Luke Chandler, head of agri commodities research at Rabobank.

He attributes this shift partly to emerging markets, where there are not just greater numbers of people, but also more who can afford more food, especially meat, which is more resource-intensive than a grain-based vegetarian diet.

Increasing use of biofuels has also pushed up demand for maize in particular.

So how should investors gain exposure to this market cycle?

Apart from going into farming, a questionable strategy, since the farmer is at the mercy of the combined and uncontrollable risks of the weather and government policy, there is a range of options.

One route is to buy an exchange traded fund tracking a soft commodity index or individual commodity.

These claim to offer the precise return of the underlying price index.

Investors should be wary, however, of how the product is structured. No ETF provider is keen to store grain or cocoa, so the price tracked is likely to be that of a futures contract, which brings in the risks of contango or backwardation – differences between the prices of contracts that squeeze the investor trying to maintain an even exposure.

Another decision ETF investors must make is whether to choose an individual commodity or to track a broad-based index such as S&P GSCI (formerly the Goldman Sachs Commodities Index).

The creation and success of this index led to accusations from some commentators that speculative investment in agricultural commodities has contributed to rising prices and volatility.

“There has been a significant influx of investor money,” agrees Mr Chandler, who concedes some volatility may be due to high frequency traders who have recently entered this market, “but overall a large percentage of the increased volatility is due to lack of stock”.

Investors who are uncomfortable with the volatility or the ethical questions around “speculative investing” can look to equity equivalents, such as the BlackRock World Agriculture fund, investing in agricultural chemicals, equipment and infrastructure, commodities and food, biofuel, crop sciences, farmland and forestry.

Such funds, also available from Schroders or Pictet, could be said to offer a way of betting on commodity prices, but with the disadvantage of increased correlation with other equities, undermining the diversification benefits from the allocation to agriculture.

More adventurous investors might look at investment in agricultural land – in many parts of the world, farming is becoming a large commercial enterprise.

This has its own problems. On the one hand, buyers of large tracts of fertile land are likely to run into competition from sovereign wealth funds, while on the other, governments may not look kindly on foreigners buying up their land.

In addition, some anti-poverty campaigners are starting to call on governments to support small farmers as they struggle to prove title to their land and work out efficient ways of bringing produce to market.

FT