A Farming Fund Sprouts Up

The PowerShares DB Agriculture Fund (AMEX: DBA), based on the Deutsche Bank Liquid Commodity Index -- Optimum Yield Agriculture Excess Return, is a new vehicle for anyone who wants to invest in agricultural commodities without opening a futures account. However, this new exchange-traded fund, launched just this year, comes with complex structural and tax issues and may have hit the market at a point when the commodity rally has peaked.

The fund is benchmarked to an index intended to reflect the performance of the agricultural sector and consists of futures contracts on corn, wheat, soybeans, and sugar. The index is rebalanced annually during November so that each commodity continues to be equally weighted. During the year, the weight of each commodity in the index will change; in early January, it stood at nearly 27% for corn, 25% for wheat, 26% for soybeans, and 22% for sugar.

An ETF such as this that uses commodities futures can offer three sources of return -- the movement of the futures prices, the positive or negative effects of backwardation or contango, and the income from the bond and cash portion of the portfolio that's used for collateral.

However, the relationship between the spot price of a commodity and the value of longer-dated futures contracts can either hurt or help investors. Futures and spot prices are affected by factors such as storage costs, geopolitical events, supply and demand, and interest rates.

What's more, investing in commodities futures is not as straightforward as investing in equities. Where you are on the futures curve and how often you roll affects your return. Futures contracts are continually "rolled" and settled at the settlement price fixed on the last trading date of the contract (i.e., at the end), rather than taking physical delivery. Because futures can trade off the prices of actual market prices for the various commodities, an investor's end return can look different from the actual price return of the target commodity.

Contango, a condition in which the next-to-expire futures contract is trading at a lower price than contracts expiring in later months, works against investors when they roll over their positions into new contracts upon the expiration of the old contract. In 2006, crude-oil futures were often in a state of contango. In such a situation, rolling the futures could result in returns lower than the price of the underlying commodity.

The opposite market condition to contango is known as backwardation, in which futures contracts closer to expiration trade at higher prices than those that are far from expiration. This condition can boost rather than lower returns when contracts are rolled. Backwardation may indicate supply insufficiencies in the corresponding physical spot market.

The income from short-term U.S. Treasury bills and cash, which are used as collateral for the futures, should offset this ETF's expense ratio of 0.91%. This income is expected to be roughly equal to the yield on three-month Treasury bills.

But the use of futures and their tax treatment could pose problems for investors. Mark-to-market treatment, meaning any gains from futures contracts on a yearly basis, can result in a 40% or 60% tax for short-term or long-term gains, respectively.

If you want to farm the market by investing in agricultural commodities, DBA is one way to accomplish that, but be aware of this fund's complexity and the potential for a wild ride. Commodity prices are volatile and difficult to forecast, so it's difficult to determine whether a commodity rally is over or still has time to run. This fund also has some unique tax issues that could make it an undesirable holding. It's worth looking at if you're up for the challenges, but it's certainly not suitable for all investors.

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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds mentioned in this article. The Motley Fool has a disclosure policy.