Yum! International agri-commodities futures looking pretty appetizing (really)

Who knew food could be so exciting?  With more – and perhaps more importantly richer – mouths to feed in the world each year, hedge funds have taken an interest in agriculture over the past few years.  While in Brazil, we met with the alternative investment firm behind one of the country’s many agri-business success stories – a company that turns scrub land into arable land for growing soybeans and coffee for your grande soya-milk double-mochafrappacino.

Of course, most hedge funds don’t actually buy actual farmland and sell physical soybeans.  Instead, they satisfy their hunger by chowing down on agriculture futures contracts.  With the interconnectedness of the global financial system, it’s easy to think that these futures contracts are the same everywhere – that a September corn contract trades the same in Paris as it does in London, Chicago or Toronto.

But a paper in the current issue of the Journal of Alternative Investments shows that a corn futures contract with a French accent is way different than one from Des Moines. (Paper available on the CAIA website here when you’re logged in using the free registration available here.)

In “Stock Market and Agricultural Futures Diversification: An International Perspective” Kamal Simimou of Canada’s Ontario Institute of Technology writes that,

“U.S. investors can improve their stock portfolio performance by holding Canadian or foreign agricultural commodity futures…European portfolio managers and investors have potential gains from diversifying their equity portfolios by holding U.S. or Canadian-made agricultural commodity futures…It is the negative correlation between the key variables that accounts for the potential gain from such diversification…”

Smimou constructs benchmarks of commodity futures for Canada, London, Paris and the US (a combination of contracts traded in Chicago, Minneapolis and Kansas City).  He then calculated the correlations between several equity indices and his agri-commodity benchmarks.

Two things are apparent from the correlation matrix below: one, the agri-commodity benchmarks are most correlated to their own domestic equity markets (makes sense), and two, several of the benchmarks had a negative correlation to foreign equity markets (namely the Canadian benchmark).

With low and negative correlations throughout this matrix, how could you not like the potential diversification properties of these international futures?  As you might have guessed, portfolio optimizers like them too.  The chart below was constructed with data from Exhibit 9 of the paper showing the optimal (highest Sharpe) portfolios when adding each benchmark to the optimal basket of equity indices.  (Note the optimizer apparently turned its nose up at the DAX and CAC40).

As you also might have guessed, adding these international agri-commodity benchmarks to the diversified global equity portfolio gave a nice kick to the Sharpe ratio – especially when they were all added.  The chart below shows mean monthly returns and standard deviations and was created with data from Exhibits 9 and 10 (Sharpe Ratios in red).

The paper contains a lot more data on the relationship between agri-commodity futures in various regions and the effects of adding them to a portfolio of equities.  But the moral of the story is clear: International diversification doesn’t end with a basket of equity indices.

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