Farmland: An Uncorrelated Asset Class

Even if you’ve never read the 1615 novel “Don Quixote” by Miguel de Cervantes, chances are you’re familiar with a popular sentence from the book:

“It is the part of a wise man to...not venture all his eggs in the same basket.”

Cervantes might not have been talking about his portfolio, but this idea around diversification is at the heart of portfolio management.

Before we dive into the diversification traits of farmland, let’s take a look at why diversification matters and how it has evolved in today’s modern financial environment.

History of Portfolio Diversification

In 1952, Harry Markowitz published “Portfolio Selection”, a mathematical analysis of investments that introduced the concept of portfolio risk. That paper is credited for helping develop the concept of an “optimal portfolio” - a collection of investments that produces the maximum return for any given level of risk. Instead of trying to generate the highest returns possible, this theory states that investors should strive to generate the highest returns for their desired level of risk. Under modern portfolio theory, the correlation between two assets is a measurement between 1.0 and -1.0 where higher values indicate high positive correlation, low values indicate negative correlation, and 0 indicates no correlation.

The way investors diversify has substantially changed over time. The early days of portfolio diversification led to blended portfolios with stocks and bonds. By the 1980’s, investors began to diversify by investing in different geographical areas through emerging equity markets. Favorable legislation and international economic growth led to a rise in commercial real estate investments during the 1990s. Today, the rise of technology and development of fintech digital platforms like FarmTogether allow investors to easily diversify their portfolio with investments that were previously less liquid or accessible..

Diversification In the 21st Century

Correlation ebbs and flows - macroeconomic, political or social conditions (such as COVID-19) change the relationship between two assets. For example, temporary fiscal policy, increased discretionary monetary policies, or changes to the economic output of an economy have historically led to higher traditional asset correlation. For these reasons, the rolling one-year correlation between stocks and bonds has dramatically increased since the start of 2021. A traditional 60/40 portfolio of today mitigates risk and generates returns differently than when Markowitz birthed his portfolio risk theories.

The correlation between other asset classes has tightened over the past few years as well. Real estate’s correlation to equities has widely swung over the past two decades. The Morningstar US REIT Index had a correlation of 0.94 to equities in 2020, and commercial real estate REITS have a correlation of 0.75 with large-cap stocks over the past three years. 2020 was also a historic year for the relationship between gold and the S&P 500. Not only did the correlation between the S&P 500 and gold turn positive, both asset classes hit all-time highs during the same calendar year for the first time since 1979. Diversifying across equity classes might not mitigate risk either; when adjusting for time zones, U.S. equities held a high correlation with Japanese (roughly 0.7) and European (0.45) equities between 1991 to 2021.

Not only have traditional assets become more correlated with each other, evidence suggests correlation strengthens during bear markets. During previous times of economic downturns when investors need the greatest amount of portfolio protection, correlation between asset classes unfortunately becomes the strongest. With numerous signals indicating a potential bear market is approaching and with so many asset classes already moving in tandem, it’s a great time to consider alternative investments like farmland that don’t have a strong correlation to other investments.

Comparing Farmland To Other Investments

Farmland is a unique asset class that doesn’t share many investment characteristics with other opportunities. Here’s a look at how farmland correlates (or doesn’t) to other popular investments.

Farmland vs. Stocks

In the past, farmland returns haven’t been correlated to equity returns. Since 2000, the correlation of these two asset classes has been 0.07, indicating neither a positive or negative connection. Going back even further, the relationship softens even more; U.S. farmland and the S&P 500 have a -0.06 correlation over the past 30 years. In general, farmland performance has been almost entirely unrelated to equities in the past. Farmland has historically experienced much less volatility compared to the S&P 500. Also, from 1992 to 2021, farmland returns were higher than that of the stock market. Investors looking for alternatives that aren’t tied to broader financial markets will take solace knowing farmland has performed independently of stocks.

Farmland vs. Bonds

Farmland and bonds have had a moderately inverse relationship over the past 20 years. With a correlation of -0.39 from 2000 to 2020, farmland and bond returns tended to actually move in opposite directions. Farmland’s volatility does mirror that of 10-year Treasuries, though farmland yields were more than twice that of fixed income bonds over the past decade. Farmland and bonds also have a history of acting differently from each other in response to inflation. Over the past 40 years, both investment grade bonds and U.S. Treasuries reacted negatively to higher inflation. Meanwhile, farmland’s 70% correlation to the Consumer Price Index meant farmland would historically move in tandem with inflation. Farmland has simply been a stronger diversifier and better inflation hedge than bonds in the past.

Farmland vs. Gold

Since 2006, farmland’s correlation to gold has been 0.53, a relatively high positive correlation. However, there’s several key differences to these assets that make them very different investments. First, gold can only appreciate in value, while farmland can appreciate in value while also generating cash through operations. Though cash yields heavily vary between geographical area and crop offering, FarmTogether investments have previously averaged annual cash yield between 3% and 9% and provide an additional hedge against inflation. Second, gold’s supply slightly increases each year while arable farmland is a depreciable asset. Third, broad demand for the two assets is not correlated. Gold experienced declines in demand during the pandemic, while agriculture experienced less volatility and stable global demand resistant to financial markets.

Farmland vs. Commercial Real Estate

Although both farmland and commercial real estate have real assets that generate monthly cash flow, the two assets had a correlation of only 0.42 the past several decades. There’s also a few differences between these two assets worth mentioning. In the past, commercial real estate’s returns have been more volatile than farmland. Second, the commercial real estate industry was dramatically impacted by COVID-19. While the future of in-person offices and commercial real estate remains to be seen, farmland values have continued to perform exceptionally well during 2021.

Farmland: The Portfolio Diversifier

Migeul de Cervantes is also credited with another popular quote: “To be prepared is half the victory”. In this unprecedented economy, it’s critically important your portfolio is ready for whatever comes. Not only has farmland been traditionally uncorrelated to many assets, it also has a history of being uncorrelated to economic cycles and broad market conditions. People need to eat, and there will always be demand for agriculture.