Grain ETFs – Seeds of Diversification
Author: Ticker Magazine
Last Update: Mar 04, 12:22 PM EST
|While agricultural commodities represent a huge and important global market, they have been off the radar of investors because of the difficulties trading them. Sal Gilbertie, founder and CEO of Teucrium Funds, has created commodity-specific ETFs, designed to make commodity exposure accessible and mitigates the structural trading hurdles.
“We are the only grain experts to have publicly traded funds and are willing to share our knowledge and to provide a way to get exposure to grains. That makes us unique more than anything else.”
Q: What is the genesis of Teucrium Funds?
I established Teucrium Trading in 2009. Prior to that, I was a principal trader for Société Générale’s Fimat division, which later became Newedge. I was trading about 30 different commodities providing liquidity off the futures exchanges. I started at Cargill in 1982, trading leaded gasoline and created an ethanol swap contract based on futures, which were not widely traded. The financially settled swap that I created took off extremely well.
So, I ended up with a desk trading 30 commodities for institutional market participants. Some of the investors were large ETFs, mostly energy-related, who needed off-exchange liquidity because their positions were too big, especially when they rolled. That’s when I realized that I could create a better ETF, so I left the bank and started Teucrium.
Initially, we had seven funds. They included our current funds, which are the four large agricultural commodities of corn, soybeans, wheat and sugar, as well as a fund of these four funds. We also had two energy ETFs. My original idea was to create a better crude oil ETF and a better natural gas ETF, because I was doing massive over-the counter business for energy ETFs. Over the course of two years, the two energy ETFs were listed and outperformed their category, but no one bought them, so we delisted them.
Q: What is the purpose of the funds?
We launched the Corn Fund in 2009 with the idea to provide direct access to commodities, specifically grains, because most people are not familiar with futures or are incapable of trading them. Most pension funds and endowments are not allowed to trade futures; they gain their commodity exposure in other ways.
Our funds are intentionally designed to be simple, transparent and unleveraged. I used my knowledge of futures and individual commodities to design an ETF that overcomes the initial problems of commodity ETFs.
When the first oil ETF came out, billions of dollars poured into it because it provided immense liquidity and the market was hungry for direct exposure to crude oil. The demand was enormous, but people didn’t understand the short-term trading issues. When investors hold on for longer than four or six weeks, they might have a problem because of the contangoed pricing nature of the market. The investors holding a $99 crude contract would have to replace it with a $100 one, when that contract rolls or sells out. We can’t remove that inefficiency completely, but each of our funds is designed to mitigate it in the best possible way.
Q: How is the firm different from its peers?
We have an area of expertise that no one else in the public domain has. The only people who know as much about grains as we do, work for hedge funds or for big grain trading companies. We literally stand alone with our knowledge in a niche and unique market, which doesn’t have a wide body of expertise. We are the only grain experts to have publicly traded funds and are willing to share our knowledge and to provide a way to get exposure to grains. That makes us unique more than anything else.
Q: How do you create an ETF?
We created the ETFs with the understanding that most investors are not traders. They would be holding the products for some time, maybe a year or longer. The funds are designed for buy-and-hold investors with diversified portfolios who want direct exposure to commodities. I wanted to mitigate the negative effects of contango and backwardation, so each ETF was designed around each specific commodity.
The ETFs facing the most criticism were the ones that concentrated their holdings in the spot month or the first nearby month. I decided not to hold the spot month because it is the most inefficient month for a long-term, buy-and-hold investor, as it deepens the effects of contango and backwardation. Nevertheless, we want to be with that movement and, as a result, we own the second and the third futures month. In that way we are not rolling too much; we are spreading our holdings across multiple contracts and we get most of the benefits of the spot movement.
The next step is choosing an anchor month, which is unique for each commodity. For example, he Corn Fund, which is our largest and most popular fund, owns the second and the third month futures and December following the third month. In the northern hemisphere, where more than two-thirds of the world’s corn is grown, December is the natural hedge, because the crop is harvested between September and December. September is too early, so December is the one that professionals are looking at and farmers are using for hedging. Investors want their money to be where professional money is, not at the front month, where people are trading at headlines.
When corn has the second, the third and the anchor month of December, we are rolling only about a third of the portfolio. The first contract that we hold is 35%, the second contract is 30% and the last contract is 35%. So, we only roll about a third of the portfolio five times a year, while oil rolls 100% 12 times a year. In simple math alone, we mitigate many of the damages that can be done by contango. Also, in several months of each calendar year we own two Decembers, so we own two crop years of corn. That approach gives investors true exposure to the commodity.
Q: How correlated are grains to the broader market? Why should investors consider them?
According to a 20-year study, gold is 0.48 correlated to the S&P 500 Index, while grains are roughly 0.20 correlated, so they have less than half the correlation of gold. That’s one of the reasons for grains to become more popular. In 2018, during the semi-annual reallocation of one of its model asset allocation portfolios, KKR & Co. replaced its 1% gold holding with a 1% corn holding. I believe that marks a turning point on Wall Street. It is a big event, because it shows that people realize how important grains are and what a useful tool they can be.
Importantly, grains can be used as a portfolio stabilizer, because they have relatively low downside risk and substantial upside potential during a drought. Grains trade at breakeven; that’s how they work. Farmers keep planting them every year, supported by governments to keep our food supplies safe. As a result, grains trade flatly for years and are relatively stable in a portfolio. It is better for an investor to get them now, while they are trading at that breakeven pattern. In the last 12 years corn has doubled twice from its current price, but it eventually goes back.
Another advantage is the transparency and the liquidity of the investment. We are part of the ETF structure, so we must meet the requirements for all ETF issuers. One of these requirements is to publish the holdings within 24 hours of a trade. Most of the ETFs, including Teucrium, do it on the same day.
We are non-discretionary managers and we stick to the formula of holding three contracts with an anchor month. In that way investors know what they will hold when they buy our fund. We have no leverage; we are perfectly transparent and immensely liquid. All the ETFs are as liquid as their underlying commodity and the corn market is huge.
Overall, I have developed a simple, easy to understand, transparent and liquid product, designed for all investors - from the small investor with an IRA account to large asset allocators. We have consistent growth of the assets under management every year and I believe that the next time there is a drought, our growth will be explosive.
Q: What idiosyncrasies of the grain market would you want to highlight?
The uniqueness of the agricultural products comes from the fact that they are planted, grown and harvested. Then there is a huge pile of them, which keeps getting smaller until the next round of planting and harvesting. The idiosyncrasies in grains are related to the seasonality of harvesting cycles. With the end of harvest, the annual supply of grains is stored, so the market gets comfortable at peak harvest.
That is most apparent in corn, because in a normal year it bottoms with peak harvest in around October and tops out around the 4th of July, when people realize that the crop will be good. In soybeans it’s a little bit different, because soybeans are planted and harvested later than corn. The anchor month for soybeans is November. Wheat has dual seasonality, because there is winter wheat and summer wheat, so there are two times when there’s a harvest.
For sugar the anchor month is March. Sugar is ruled by global supply, because it comes from a lot of places, with Brazil and Indonesia being the major producers. There is a clear picture of global surplus or deficit; it may swing from a surplus for several years in a row to a deficit for several years in a row. So, sugar has large cyclical multiyear price swings based on projected deficits. Overall, each ETF has unique structure and a different anchor month.
Q: What are the main factors affecting the price of corn?