Caution On Red Hot Coffee ETNs

All eyes are on the bitter-dark manna, but are ETNs a safe way to play it?

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Reviewed by: Dave Nadig
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Edited by: Dave Nadig

All eyes are on the bitter-dark manna, but are ETNs a safe way to play it?

This morning’s Wall Street Journal features just the latest in a long string of articles noting the incredible rise of coffee in the commodity markets. It’s a story that’s been brewing (sorry) for quite a while now.

We first wrote about the pop in coffee back in February, when both of the major ETNs tracking coffee were up 50 percent already.

Things have only gotten more heated since:

JOCAFE

The leading ETN tracking the space, the iPath Dow-Jones-UBS Coffee Total Return ETN (JO | B-67), is up almost 95 percent on the year. That’s an astonishing run for any asset, regardless of circumstance. But let’s tease out some of the dangers here for anyone reading the Journal article and jumping on the bandwagon.

First, it’s worth pointing out that coffee is nearly the only commodity in the world in the middle of a bull market. Consider what’s going on across the asset class, courtesy of HardAssetsInvestor.com and its excellent Week In Review section:

Commodity Wrap

CommodityWeekly ReturnYTD Return
Wheat2.74%-19.50%
Soybeans1.65%-29.55%
Corn0.62%-22.99%
Natural Gas-0.25%-6.15%
Copper-0.66%-11.47%
Gold-2.06%-1.03%
Palladium-2.67%6.11%
WTI-3.25%-8.05%
Silver-4.76%-13.71%
Brent-4.79%-16.65%
Platinum-5.64%-10.41%

Among the majors, palladium is the only other commodity that’s actually up for the year, and nothing looks anything like the craziness we’re seeing in coffee.

 

As with most agricultural commodities, the story here is all about short-term supply and demand. Brazil, which harvests in May, has had a terrible year and, when it comes to coffee, Brazil is king. Brazil makes less, the world drinks more and prices go up. It’s one of the glorious things about commodity investing—sometimes it actually makes sense.

But consider that, like almost all commodities, you don’t actually buy the beans themselves, you buy futures contracts.

And agricultural contracts are used by actual producers and consumers to lock in prices. Big roasters use them to lock in prices, as do big farmers. That can lead to an enormous amount of volatility in the spot price and the shape of the futures curve itself.

Consider how you did if you jumped into coffee right before harvest got going in Brazil:

WorstCase

You may be back to even, but you weathered a 25 percent pullback. Why?

Well, the harvest wasn’t quite as terrible as everyone expected, and a lot of buyers may have already locked in contractual prices to avoid the volatility of the harvest season. Commodity futures markets, particularly agricultural ones, have a tendency to “price in” expectations for the next year very quickly. That’s why I’m very skeptical of investors jumping on a bandwagon that’s already moving along.

 

This “pricing in” of every new piece of crop information also makes it difficult for contango-beating strategies to reliably work. The two big ETNs in the space, JO and the cannibal-competitor the iPath Pure Beta Coffee ETN (CAFE | B-98), take different approaches here.

JO just returns the front-month roll version of coffee, notionally selling its position each month to buy next month’s coffee contract. CAFE uses an algorithm to buy what it thinks the most favorable position on the curve is. There’s just one problem:

Curves

This is what the contango curve for coffee has looked like last year (bottom orange), one and six months ago (the middle two lines) and today (red line).

These are barely curves, they’re lines, and by commodity standards, not particularly interesting ones.

CAFE is designed to figure out which months will likely rise as time goes on, which means buying something from the right-hand side of the chart that’s lower than the left-hand side of the chart. That’s slim pickings, and, in a nutshell, it hasn’t work. The contango here in coffee just hasn’t been tradable, and so CAFE is behind the naive approach of JO by about 8 percentage points this year.

To make matters worse, both of these ETNs fall into the category of securities with path-dependent fees. That means the tracking error to the actual indexes is pretty dismal: JO’s median tracking difference is 1.93 percentage points behind its own index, and that difference is regularly up or down 2 percentage points over any one-year holding period.

All of this should simply serve as a cautionary tale: Playing single commodities, especially “agricultural” ones, is not for the faint of heart, and definitely not something you should do based on a newspaper article with a flashy headline.


At the time this article was written, the author held no positions in the securities mentioned. He does however, enjoy a cup of coffee, especially in light of Twin Peaks returning. Contact Dave Nadig at [email protected] or on Twitter @DaveNadig.

 

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.