The Definitive Guide To Cotton ETF Investing

by on December 29, 2009 | ETFs Mentioned:

To most, cotton is a part of everyday life, a part of the textiles found in every wardrobe. But after prices surged in 2009, some investors have begun making cotton a part of their portfolio as well, and are turning to cotton ETFs as a way to gain exposure. While this soft commodity has the potential to deliver big gains and add diversification benefits, it comes with a fair amount of risk as well. And while exchange-traded products are the best way for many investors to gain exposure to this commodity, these products feature some nuances that should be considered before investing.

Cotton 101

Cotton ETFs Have Become PopularCotton is used to make a number of textile products, ranging from terrycloth and denim to corduroy and seersucker. In addition to widespread use in the production of clothing, cotton is used in fishnets, coffee filters, tents, and gunpowder.

Cotton is grown in subtropical regions around the world, including the southern U.S., India, and Africa. China is the world’s largest producer of cotton, followed by India and the U.S. The leading exporters of the commodity include the U.S. and India, as well as Uzbekistan and Brazil. Major importers include Korea, Russia, and Japan.

Cotton futures contracts, the underlying holdings of cotton exchange-traded products, are traded on both the NYMEX and NYBOT exchanges, and are delivered each year in March, May, July, October, and December.

Cotton Prices

Supply and demand for cotton can be impacted by a number of factors, ranging from extreme weather to the use of substitutes among consumers. Potential drivers of cotton prices include:

  • Acreage Allotments: Global supplies of cotton depend in large part on the percentage of usable land allocated to this commodity. Because many farmers in cotton-producing countries have flexibility to grow any of a number of crops on farmland, cotton supplies may drop if prices of other commodities jump, encouraging farmers to allocate a larger portion of available land to resources with higher margins. Currently, cotton has the smallest global acreage planted since 1986 (including the lowest U.S. plantings since 1983)
  • Weather: Like many commodities (particularly agricultural resources), supplies and prices of cotton are dependent upon weather patterns in production regions. Heavy rains can often delay harvests, while insufficient water can result in lower-than-expected outputs. Since extreme weather is impossible to predict far in advance, cotton prices can often surge on news of a potential disruption.
  • Strength/Weakness of U.S. Dollar: As with most commodities, the price of cotton is generally boosted by a weak dollar, since this makes the commodity cheaper to consumers around the world. Cotton prices will generally have a strong positive correlation with inflation, making this commodity a good hedge against a rising CPI. ETFdb Pro members can see a complete collection of “anti-inflation” ETFs in our Black Swan Hyperinflation Model Portfolio (if you’re not a Pro member yet, sign up for a free trial or read more here).
  • Overall Economic Health: Cotton prices are tied closely to demand for new clothing and textile, the purchase of which tends to be delayed during economic downturns as discretionary expenses are cut from budgets.
  • Cotton Alternatives: Synthetic fibers have become increasingly popular in recent years, and threaten to replace cotton in certain markets. To the extent that these alternative fibers increase in popularity or become more affordable, cotton prices could take a hit.

Cotton ETF Options

Cotton is included within most diversified commodity ETFs, although it is generally given an allocation of less than 5% of total holdings. As one of the “softs,” cotton is given a much heavier weighting in the iPath Dow Jones-UBS Softs Subindex Total Return ETN (JJS). This ETN allocates nearly one third of its holdings to cotton futures, with the remainder split between sugar and coffee.

For investors looking for “pure play” exposure to cotton, the iPath Dow Jones-UBS Cotton Subindex Total Return ETN (BAL) is the best option. The index to which this ETN is linked consists of a single futures contract on cotton. BAL is structured as an exchange-traded note, meaning that it is a senior, unsubordinated, unsecured debt instrument issued by Barclays Bank PLC. Since ETNs are debt instruments, BAL introduces investors to some degree of credit risk (although Barclays’ long-term unsecured obligations have an S&P rating of AA-).

BAL charges an expense ratio of 0.75%, fairly common among commodity-specific exchange-traded products. Since its inception, BAL has had a low correlation with both stock and bond funds, and only a slightly stronger relationship with diversified commodity products. Given its focus on a single commodity that can experience big price swings, BAL is one of the more volatile exchange-traded products available: in 2009 it moved by at least 1% in a single session more than half the time, and swung by at least 3% in more than one out of every ten sessions.

BAL

For investors looking to achieve some of the diversification benefits that traditionally come along with commodity investing, making a significant allocation to a single natural resource may be a bit risky — generally well diversified funds such as DJCI will be a better bet. But for those who believe cotton prices are due for an uptick, BAL has the potential to deliver big gains while also hedging against a spike in inflation.

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Disclosure: No positions at time of writing.