Agriculture serves up food for thought

Predictions of long-term potential in the agriculture sector have led investment managers to launch a number of themed funds in recent years, which are catching the attention of private investors. Their attraction is based on three long-term drivers – a rising global population, changing dietary habits in emerging markets and increasing use of biofuels. Farmers will clearly have to produce more crops to meet this demand.

“Demand has been outstripping supply,” says BlackRock’s Richard Davis, co-manager of the BGF World Agriculture fund, launched in February. “This upward pressure will make farms more profitable, and as a result of this, they will be incentivised to grow more crops. And that is where the investment opportunity lies – in the supply side response to improving farming economics,” he explains.

“If farmers do not increase the amount of food they are producing, we will see significant food price inflation, which is something governments do not want. If the price of platinum goes up and I can no longer buy jewellery, the government simply does not care. They do if the price of food goes up. We all know we are only three meals from anarchy. If you can’t eat for three consecutive meals, you will do something about it.”

For investors convinced by this argument, the question is how best to gain exposure to it. One way is to invest in commodities themselves, for example through an exchange traded fund (ETF) tracking prices of individual commodities.

Many investors are attracted to agricultural commodities because they are largely uncorrelated to equity markets, and therefore offer diversification benefits, but they can involve extreme short-term volatility. Agricultural commodity prices are dependent on a range of hard to predict factors, not least the weather.

In response to growing interest, Hedge Fund Research (HFR) launched a family of indices tracking the performance of commodity related hedge funds in 2009. “If you look back at what has transpired over the last six or seven months in the commodities space, you have seen not only a tremendous amount of volatility, but a tremendous amount of dispersion,” says HFR’s president Ken Heinz.

“A few of the major commodities are down significantly on the year, while others are up significantly. Wheat is the most obvious example. Whether the fund is focused on wheat, or natural gas or sugar, has dramatically different implications. Investors have come to understand exposure to the area to be more of a specialised undertaking and not a one-size-fits-all exposure.”

Rather than trying to predict future price moves, a number of funds are looking to play on the expectation of a broader agricultural boom, investing in agricultural equities rather than commodities themselves. These funds invest either in companies that are themselves farming businesses, owning land and growing crops, or those which sell goods and services to farmers, be it seeds, tractors, fertilizers or food producers.

“The attractiveness of equities over commodities is based on one key word – flexibility,” says Desmond Cheung, co-manager of the BlackRock fund.

“We have the ability to invest in different sub-sectors. Different companies will perform differently in different grain price environments. Some will perform well when grain prices are strong, others will benefit from the increase in production that will push down the price of grain, which challenges the myth that the only way to make money out of agriculture is when there is a food crisis and grain prices are high.”

The emergence of the biofuels industry has put further pressure on agriculture, as for the first time farmers have two customers, food companies and fuel companies. In the US today, 30 per cent of the corn crop is turned into biofuels, which has proved controversial as it is, in effect, “setting fire to food” as BlackRock’s Mr Davis puts it.

However, spurred on by climate change and the need for greater levels of renewable energy, this is only going to increase, as government legislation for increasing amounts that must be produced is driving the sector, both in the US and elsewhere.

“If Congress changed its mind, or we rethought our policy, that would be very disruptive,” says Bryan Agbabian, fund manager of Allianz RCM Agricultural Trends.

“I don’t see that happening, given the infrastructure that has been put in place. Farmers’ livelihoods would be put in jeopardy, the ethanol industry is starting to develop as well, and given that we have a President that was a senator from Illinois, I think it doubtful that there will be a significant change.”

A further benefit of agriculture themed funds is in providing exposure to emerging markets, since these are the countries that are seeing the fastest growing populations and changing dietary habits afforded by rising levels of income, and are therefore driving the sector. As populations in developing countries become increasingly wealthy, they tend to move from starch-based diets to more balanced ones, with increasing levels of protein consumption. And as a result farmers have to grow more grain to feed these animals.

Henry Boucher, Sarasin

“Some of the key drivers of the story play into this belief in the emergence of the emerging market economies,” says Jonathan Blake, manager of the Baring Global Agriculture Fund.

“We do believe that emerging nations will continue to support their agriculture industries, they will make more subsidies and more capital available, and we do believe that there will be overall therefore an increased investment in agriculture. Our fund is looking for those companies we think will be the beneficiaries.”

This does not necessarily mean investing directly into the emerging markets however. “About 30 per cent of the fund is in emerging market equities by listing, but much of the services and products and expertise in the agriculture industry resides with developed market companies,” he says.

Western companies tend to be the ones with expertise in this field, and emerging markets have to buy fertilizers and other products from North America and Europe to boost their own levels of production.

There are two ways to increase the levels of agricultural production, firstly by increasing the amount of land used to grow crops, and secondly by increasing the yields from that land. Both of these factors bring with them ethical considerations, be it the use of chemical fertilizers or through cutting down rainforests to turn the land over to farming, and many of these funds are keen to stress that, while they may not be SRI funds per se, they certainly take environmental and socially responsible factors into account.

“In environmental terms agriculture is not a perfectly clean industry,” says Henry Boucher, deputy CIO and manager of the Sarasin AgriSar fund.

“It is responsible for 70 per cent of the world’s water production and for tipping vast quantities of chemicals across the face of the earth. We have to be very careful about some of the practices in parts of the agricultural world. We look for instance at some of the impacts of over fishing. We wouldn’t particularly want to invest in ocean fishing fleets.”

Gertjan van der Geer, manager of the Pictet Agriculture fund, agrees. “We do have some SRI criteria, one of them being that we cannot invest in companies that have significant exposure to genetically modified seeds.”

He goes on to highlight the controversy regarding the clearing of forests to make way for palm oil plantations, which is particularly prevalent in Malaysia and parts of Indonesia. “We are only allowed to invest in companies that are part of the roundtable on sustainable palm oil, and we even have an advisory board member who is CEO of a plantation company that is also on the roundtable. The roundtable basically means you cannot cut down rainforest to grow palm trees. It allows you to participate in the growth of an industry in an environmentally conscious manner. By not investing in a palm oil company that actually cuts down the rainforest actually lowers your risk profile. You aren’t exposed to the companies that are getting all of the bad press and have volatile stock prices.”

Thematic investing

Agriculture themed funds are proving popular with investors as a satellite holding in portfolios, and are perhaps evidence of the growing popularity of thematic investments among retail investors in particular. “I believe that long-term thematic investing does strike a chord with investors,” says Mr van der Geer.

“Pictet run a number of very successful thematic funds, and this is the latest addition. It is a more retail oriented sector, since a lot of institutional investors think in terms of regions, rather than in terms of themes, although we are seeing increasing interest from that segment as well.”

Barings’ Mr Blake agrees. “We believe, which is why we launched the fund when we did, that there is a greater demand for thematic investments in general. This product fits very neatly alongside a traditional global equity allocation in some form or another, where this will be an alternative equity allocation into a thematic investment opportunity, and this would be one of maybe a number of thematic investments.”