The recent stock market plunge has once again reminded investors about the importance of being diversified across different asset classes to reduce their overall risk.
The uncertainty stemming from Europe’s sovereign debt crisis, S&P’s downgrade of U.S. debt and a slew of weak economic numbers have investors questioning whether we’re headed for another recession.
But predicting recessions is tough, and fully positioning your portfolio based on your convictions can be costly if you’re wrong.
A better approach may be to diversify into assets whose returns have low correlation with the daily movements of the broad market. To that point, two popular agricultural commodity funds have recently been flying under the radar and holding up extremely well.
Since Aug. 1, the SPDR S&P 500 Fund (NYSEArca: SPY) is down roughly 8.5 percent—but during this same period, the PowerShares DB Agriculture Fund (NYSEArca: DBA) and the Elements Rogers International Commodity - Agriculture Total Return ETN (NYSEArca: RJA) have done just fine, returning a stellar 4.2 percent and 4.7 percent, respectively.
DBA and RJA are both broad-based funds that provide investors with exposure to an array of agricultural commodities, including sugar, corn, wheat and soybeans.
DBA aims to track the DBIQ Diversified Agriculture Excess Return Index, and holds futures contracts from roughly 11 different commodities. DBA is the larger of the two funds, with over $2.8 billion in assets under management, compared with $619 million for RJA.
RJA is an exchange-traded note (ETN) that tracks the Rogers International Commodity - Agriculture Total Return Index. The benchmark, created by commodities guru and famed investor Jim Rogers is a bit more comprehensive than DBA’s index, and is composed of futures contracts from 22 different commodities.
With the world population projected to hit 9 billion by 2050, and with rising concerns about global warming and drought, the long-term growth prospects for agriculture seem exceedingly bullish. But agricultural commodities can also provide a hedge against inflation, which might be the big appeal here.
In mid-August, the Federal Reserve surprised markets by pledging to keep interest rates near zero percent at least until mid-2013. The Fed also said it would stand ready to act if the economic outlook worsened, hinting at further stimulus, which many economists consider to be inflationary.
For investors considering diversifying into agriculture, there are fundamental differences between the two funds that should be understood before making an investment decision.
DBA is structured as a partnership for tax purposes and holds futures contracts. Therefore, 60 percent of gains are taxed at the long-term rate, with the remaining 40 percent taxed at the short-term rate, regardless of how long the shares are held. This comes out to a 23 percent blended maximum rate.
DBA is also marked-to-market at year-end, so investors can be subject to pay taxes on any gains even if shares aren’t sold. Finally, gains and losses are reported on a schedule K-1 form, instead of the 1099 that most investors are accustomed to.
RJA, on the other hand, is an ETN and actually doesn’t need to hold anything—it’s simply an unsecured debt note that tracks its underlying index. For tax purposes, RJA is currently taxed at the 15 percent long-term rate if held for more than a year, and taxed as ordinary income if shares are held for a year or less.
The catch is that RJA carries credit risk of the bank issuing the note. It’s crucial to note that even though RJA is a Merrill Lynch product, the bank issuing the note isn’t Bank of America, but rather the Swedish Export Credit Corp.
So, DBA and RJA can be beneficial to different types of investors, depending on your time horizon and personal preferences regarding taxes and credit risk.
Investors often seek diversification using different global equity and fixed-income funds, but due to increased integrated global markets, it’s getting difficult to find uncorrelated funds.
Both DBA and RJA continue to look like good diversification plays, and have shown the importance of being diversified not only across various funds, but also across different asset classes.
Disclosure: I am currently long RJA.