Agricultural sector on a roll
Financial futures such as stock indices, interest-rates, and currencies may have garnered most of the headlines in recent years, but commodity futures are an integral part of the futures landscape and can play an important role in any diversified managed futures investment.
In the recent commodity bull market, oil and metals may have been leaders in the overall uptrend, but sizable trends (up and down — managed futures programs can profit in bull and bear phases) emerged in several agricultural commodities, including grains (Figure 1). Big rallies in corn and soybeans, for example, unfolded in the second half of 2010 and extended into 2011 before turning in spring. Table 1 shows that in addition to grains and livestock, the agricultural sector spans a wide range of products, including lumber, dairy, and other foodstuffs. (For a complete list of agricultural markets, go to www.cmegroup.com.)
These markets all offer unique trading opportunities that can contribute to a diversified managed futures investment program. Figure 2 highlights the increased interest in the sector in recent years, showing the growth of assets under management (AUM) in agricultural managed futures programs tracked by BarclayHedge since 1999. A steady uptrend from Q2 2004 into 2008 was temporarily interrupted by the financial crisis, but the second half of 2010 saw a return to net inflows, and a meteoric rise in the fourth quarter of the year when AUM topped $1.5 billion — more than double the Q3 total.
Figure 3 shines more light on the flow of funds into agricultural managed futures funds. The chart shows the annual returns for the BarclayHedge Agricultural Traders Index along with the index’s Value-Added Monthly Index (VAMI), which represents the equity growth in a hypothetical $1,000 investment. The long-term uptrend in equity is evident, but returns have been on an even more notable rise since 2004. The index has had only one losing year since 2006, and 2010’s 11.74% return was the second highest (after 2004) in the past decade. (Note: Figure 3 does not include 1988’s 95% return, which would have distorted the chart’s scale.)
With approximately 80% of funds reporting in late May, the Agricultural Traders Index was up 2.3% through April 2011 — the second-best year-to-date return of all the commodity trading advisory (CTA) indices tracked by BarclayHedge.
Trading agricultural futures
In addition to having a diverse group of markets to trade, agricultural fund managers can make use of certain trading tools and approaches that are less applicable to other markets. As shown in Figure 1, agricultural commodities can embark on extended trends that reap large profits over time, but the unique characteristics of many ag markets allow managed futures traders to take advantage of more than just general market direction.
In addition to employing fundamental analysis of the supply and demand factors of the physical commodities, agricultural futures traders often use techniques such a “spread trading” to take profits out of these markets, regardless of whether they are moving up, down, or sideways.
Instead of going long or short a particular market, spread trading consists of simultaneously going long one market and short another related market (an “intercommodity spread”) or long one contract month and short another contract month in the same commodity (an “intracommodity” or “calendar” spread). The goal is to trade the difference, or spread, between the two markets or contracts, which will have a relationship independent of whether the overall market is going up down.
Spread trading is particularly applicable to many agricultural markets because unlike most financial futures where the underlying is the same from contract month to contract month, individual delivery months in agricultural commodities represent distinct (but still related) assets because of differences in harvests. For example, a well-known intracommodity spread is the July-November soybean spread, which is also known as an “old-crop/new-crop” spread because the soybeans available for delivery in July are completely different beans from those available in November.
Seasonal factors tied to the growing and harvest seasons for different agricultural commodities, as well as the production cycles for their products, also provide catalysts for trades, some of which can be captured using spread techniques. The “crack spread” in the oil market (which involves simultaneous positions in crude oil and two of its refined products, heating oil and gasoline) and the “crush spread” in soybeans (which trades the relationship between beans, soybean oil, and soybean meal), are examples of the more sophisticated trades managers can use in this area. (See “Spread trading: Capitalizing on market relationships” for more information about this trading approach.)
Diversity and independence
Agricultural futures provided the foundation for the exchange-traded futures industry more than 150 years ago, and they continue to play a vital role. Because of their unique characteristics, agricultural futures offer diversification not just from larger asset groups such as equities and interest rates, but also from other sectors of the managed futures space.
