Building a Diversified Farmland Portfolio: A Case Study
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Most investors know that diversification is a primary principle of investing. As many asset managers have pointed out, real assets like farm and timberland can be a key diversifier to stock/bond-heavy portfolios, especially in today’s economic climate.
AcreTrader offers investors access to these alternative real assets through its online investment platform.
This backward-looking portfolio allocation case study examines the effects of introducing farmland assets to a hypothetical 60/40 stock/bond portfolio, as well as different diversification scenarios with respect to crop, region, and climate.
For a more comprehensive introduction to this topic, read How to Diversify a Farmland Portfolio.
- Farmland values have historically correlated with inflation, indicating its potential as an inflation hedge.
- Adding farmland to a hypothetical 60/40 portfolio increased the portfolio’s overall risk-adjusted return.
- Diversification within a hypothetical farmland portfolio—with respect to crop, region, and climate— was shown to reduce risk and boost relative returns.
- Investors should bear in mind that alternative investments like farm and timberland are considered speculative in nature, and each investment has different risk/reward potential.
Inflation Hedging Potential of Allocating to Farmland
One reason investors have historically invested in farmland is its correlation to inflation. Farmland, due to its direct tie to food, fuel, and fiber (key elements of the Consumer Price Index, a primary inflation measure), has historically moved with inflation. This relationship could provide a hedge against inflation when land is added to a portfolio, as has been the case in the past. Keep in mind, investing in alternative assets involves risk, including loss of principal, and may involve high costs. Investments in farm and timberland are considered illiquid.
Past performance does not guarantee future results and there is no guarantee this trend will continue. “Farmland”= aggregate return series comprising rental income plus appreciation less estimated property taxes, divided by initial value of farmland in the top 32 states ranked by agricultural activity. “CPI”=Consumer Price Index, a common inflation measure computed by the U.S. Bureau of Labor Statistics.
Risk-Adjusted Returns in a Farmland Portfolio
Farmland as an asset class has historically outperformed both stocks and bonds, as measured by returns to the S&P 500 and Bloomberg AAA bond indexes between 1992 and 2022, on a risk-adjusted basis. A common methodology used to measure risk versus reward is the Sharpe ratio. This measures the returns of an asset class, above the risk-free rate, versus the volatility of that asset class. The higher the Sharpe ratio, the higher the risk-adjusted returns.
The National Council of Real Estate Investment Fiduciaries (NCREIF) collects investment return data separately on timberland, leased row cropland, and directly operated permanent cropland. From this point on in this case study, we use the term “farmland” to signify an equally weighted portfolio of these three indexes.
In a diversified portfolio of timberland, leased row cropland, and directly operated permanent cropland, we see a Sharpe ratio over double that achieved by the S&P 500 and AAA bonds. This higher ratio implies that adding land to a hypothetical 60/40 portfolio increased risk-adjusted returns.
Past performance does not guarantee future results and there is no guarantee this trend will continue. For illustrative purposes only and is not intended to represent a real investment. Indices do not address investment costs. You cannot invest directly in an index. There are significant differences between public and private equities, including but not limited to public equities can provide liquidity and greater access to company information and private equities have a longer time horizon and are considered illiquid. Bonds include ratings by NRSRO as indication of issuers creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. Data represents based and recognizable indices and is intended to show performance in different asset classes. Risk/reward profile for each asset class varies significantly. “Farmland” = NCREIF Annual Cropland Index, Permanent Cropland Index, and Total Timberland Index, Q2 1992-Q4 2022, excluding Q2-Q3 1999, for which no data is available. A 3% risk free rate is used to calculate Sharpe ratios.
In the next chart, we run this analysis and find that a hypothetical portfolio consisting of 48% stocks, 32% bonds and 20% farmland would have had 31% higher risk-adjusted returns than a 60/40 stock/bond split since 1992.
Past performance does not guarantee future results and there is no guarantee this trend will continue. “0%” indicates a hypothetical investment portfolio consisting of 60% S&P 500 and 40% Bloomberg AAA Bonds Index; this portfolio achieves a baseline Sharpe ratio of 0.58. Each successive bar represents the increase in risk-adjusted returns, as measured by the Sharpe ratio, achieved by adding farmland in increasing allocations to the 0% baseline. Each successive portfolio represented allocates non-farmland-invested capital to a 60/40 mix of these two indexes. Thus, a 20% allocation to farmland has a 31% higher Sharpe ratio than the baseline 60/40 portfolio. A 3% risk free rate is used to calculate Sharpe ratios.
This increase in risk-adjusted returns can be seen with the addition of timberland, directly-operated permanent cropland, and leased row cropland, as seen below. This chart highlights the increase in risk-adjusted returns achieved with the addition of each asset class, as measured against a 60/40.
Past performance does not guarantee future results and there is no guarantee this trend will continue. “0%” indicates a hypothetical investment portfolio consisting of 60% S&P 500 and 40% Bloomberg AAA Bonds Index; this portfolio achieves a baseline Sharpe ratio of 0.58. Each successive bar represents the increase in risk-adjusted returns, as measured by the Sharpe ratio, achieved by adding farmland in increasing allocations to the 0% baseline, according to the percentage allocated to the specific asset class. Each successive portfolio represented allocates non-farmland-invested capital to a 60/40 mix of these two indexes. Thus, a 20% allocation to farmland has a 31% higher Sharpe ratio than the baseline 60/40 portfolio. A 3% risk free rate is used to calculate Sharpe ratios.
Crop Diversification Within a Farmland Investment Portfolio
While diversification does not guarantee a profit or protect against loss in a declining market, it may be able to help reduce what is referred to as idiosyncratic risk. This type of risk is specific to an asset. One such risk specific to a farmland asset might be changes in the price of the crop being produced.
Whether through a flex lease or direct operational exposure, as in the case of permanent crop and timberland offerings on the AcreTrader platform, the price of a crop can determine the yield of your investment. Therefore, diversifying your farmland portfolio amongst crop types could provide some protection against this risk.
In the chart below, we start with a portfolio consisting of a corn and soybean farm. To this we successively add new investments with exposure to different crop types. We see that the volatility of the portfolio’s crop mix decreases as new crops are added.
Past performance does not guarantee future results and there is no guarantee this trend will continue. Crops are selected to represent a typical portfolio construction on the AcreTrader platform. Successive additions of crop types flow from left to right, beginning with only corn and beans, and adding crops one by one to reach the rightmost portfolio containing all crop types listed in equal proportions.
Regional Diversification in a Farmland Investment Portfolio
We also used USDA data on farmland prices to analyze how the addition of new regions could increase the risk-adjusted returns of a portfolio. We see that, using the USDA’s 10 distinct farming regions, the average 1-region portfolio has seen a Sharpe ratio of 0.86 since 2000. This compares to a ratio of 0.98 for a 5-region portfolio, an increase of 14%.
The chart below shows the incremental gains which could be made by adding new regions, as shown in historical data. Increasing the amount of regions a portfolio is exposed to could help to diversify against risks specific to farming regions, such as changes in tenant density, profitability of local crops, and climate factors.
Past performance does not guarantee future results and there is no guarantee this trend will continue. The Sharpe ratio for each category is the average Sharpe ratio for all possible combinations of the USDA’s ten designated agricultural regions in equally weighted portfolios. The ratios calculated are average ratios of the 10, 45, 120, and 252 different possible portfolios for 1-, 2-, 3-, and 5-region combinations respectively. A 3% risk free rate and 2.5% net cash yield is used to calculate the Sharpe ratio of each portfolio from USDA data. Each successive bar represents the incremental increase in risk-adjusted returns, as measured by the Sharpe ratio, when new regions are added to the baseline of the previous portfolio.
Climate Diversification in a Farmland Investment Portfolio
Another factor that could prove important when structuring a farmland portfolio is climate. Weather patterns differ across the U.S. and around the globe. For example, drier conditions in the American West often correspond to wetter conditions in Australia, and vice versa. Weather events could impact farm yields, which could impact returns to a land investment.
The chart below shows the standard deviation of rainfall achieved by various portfolios. We see that, using data since 1970, adding regions such as Minnesota’s Red River Valley, Georgia, and Tasmania, Australia to a portfolio containing Iowa farmland has historically reduced rainfall volatility.
Past performance does not guarantee future results and there is no guarantee this trend will continue. “Regions”= NOAA average rainfall collected by representative weather stations within each region. Regions are selected to represent a typical mix of locations of properties historically offered on the AcreTrader Platform. Regions are added successively left to right, starting with Iowa only and adding regions. Data accurate as of 2021.
Farmland as an asset class has historically provided strong risk-adjusted returns and could increase the Sharpe ratio of a more traditional 60/40 portfolio. It can also serve as an inflation hedge.
Many factors, including crop type, region and weather can add risk to a land portfolio. In this analysis, we find that the volatility caused by these factors has historically been reduced with diversification across crop types and regions.
Visit our investments page to explore current opportunities to diversify your farmland portfolio.
The above content is not intended to be a comparison between products, but is intended for general, educational and informational purposes only. Any performance noted is historical and there is no guarantee any trends will continue. All investing involves risks, including the complete loss of principal. Diversification does not guarantee a profit or protect against loss in a declining market. It is important for each investor to review their investment objectives, risk tolerance, tax liability and liquidity needs before investing. Investment vehicles have differences in fee structure, risk factors and objectives. Investments are considered speculative, involve a high degree of risk and therefore are not suitable for all investors.Sharpe Ratio (Risk-Adjusted Return) is a risk-adjusted return measure calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe Ratio, the better the historical risk-adjusted performance. Standard Deviation (Risk) is a statistical measure of the historical volatility; the higher the number, the greater the risk.
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