Interest in natural capital is rising, and natural resource asset classes such as timberland and farmland are attracting greater investor attention for their potential to positively impact the environment, while augmenting the returns generated from traditional management.

Natural capital’s historical investment performance and interaction with traditional asset classes indicate that its inclusion within multi-asset investment strategies can achieve the financial objectives of long-term institutional investors – offering competitive risk-adjusted and long-term stable returns, enhancing portfolio diversification and preserving capital.

These investment characteristics are supported by sound market fundamentals, driven by the increasing human need for shelter, food, feed, fuel and fibre.

Timberland investments provided average annualised real US dollar returns of nearly 7 per cent between 1991 and 2022, and nominal returns of 9 per cent.

Over the same period, real returns for investments in farmland averaged 8 per cent. They were nearly 11 per cent on a nominal basis.

In addition, timberland and farmland have performed well on a risk-adjusted basis over the last 25 years. With Sharpe ratios of 1.47 and 0.91, respectively, farmland and timberland compare favourably against most traditional financial assets.

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When timberland and farmland are combined in a hypothetical 50-50 allocation, the resultant pro forma natural capital portfolio would have produced a favourable Sharpe Ratio of 1.3 over this time frame.

Diversification benefits

Timberland and farmland can play a role in improving the overall performance of a mixed-asset portfolio through diversification due to their low – and in some cases negative – correlations with other assets.

Meanwhile, timberland and farmland returns have maintained an average correlation of 0.77 with each other over the past 20 years – a positive but not perfect correlation, due in part to variations in market dynamics specific to each asset class.

This allows for the inclusion of both assets in a larger portfolio to provide diversification and an expanded natural capital investable universe.

Our timberland and agriculture investment strategies also include diversification within each asset class across regions, timber species and age classes, crop types, end-products, and markets to help mitigate risks from weather, pests, diseases, natural disasters, and macroeconomic and market-specific factors.

Compelling market fundamentals

Population growth, demographics and economic development continue to drive demand for shelter, food, feed, fibre and fuel, forming the foundation for key end-use markets for timberland and farmland products.

This growing demand should be juxtaposed against a decreasing supply of available arable land and limited availability of commercially operable timberland.

These factors will place increased pressure on managers to farm crops and manage timber plantations in the most efficient and environmentally sustainable manner, and use technological and scientific advancements to increase productivity.

Timberlands are biological wood factories that grow in volume and value over time regardless of the macroeconomic environment, and their carbon sequestration capabilities are now more explicitly valued.

During periods with weak market conditions, timberland owners can defer their harvest operations and allow their trees to grow in both volume and value.

Taking into account carbon value potential, this strategy provides additional optionality in certain timber production regions.

Scientific and technological advancements in genetics and silviculture can also increase yield while mitigating risks from extreme weather, natural disasters and disease.

Farmland productivity gains are crucial to meet growing demand from an increasingly limited area of available arable land, and new advances in genetics and agronomy are sustainably improving farmland yields while tempering input costs and promoting long-term soil health.

Farmland values may benefit from the additional volume and higher-quality crops produced, as well as the soil’s potential to store carbon.

Constructing an efficient frontier with US timberland and farmland

To illustrate the benefits of adding both timberland and agriculture to an institutional portfolio, we constructed a pro forma 50-50 timberland and farmland portfolio to be placed within a hypothetical mixed-asset portfolio similar to one held by a typical institutional investor.

An efficient frontier was generated for this portfolio without an allocation to US timberland and farmland investments.

A second efficient frontier was then generated, allowing for an allocation of up to 7 per cent for a 50-50 timberland and farmland investment, using data from the National Council of Real Estate Investment Fiduciaries.

Our analysis found that the inclusion of timberland and farmland can improve the risk/return profile by shifting the efficient frontier upwards and to the left.

The optimal portfolio with timberland and farmland, defined as the portfolio with the highest Sharpe ratio, generated a slightly higher nominal annual US dollar-based return of 7.4 per cent, compared with 7.3 per cent for the optimal portfolio without them, while having a significantly lower volatility than the portfolio without an allocation to timberland and farmland.

The Sharpe ratio of the optimal portfolio improves from 0.57 to 0.96 after the inclusion of timberland and farmland – a 68 per cent enhancement in risk-adjusted return performance.

The mean-variance analysis demonstrates how including natural capital asset classes, such as timberland and farmland, in a multi-asset institutional portfolio may offer the potential to enhance the portfolio’s overall risk-adjusted returns.

A rising focus on natural capital

In addition to the benefits of improved financial performance, the rise in interest and importance of natural capital dovetails with our long-held belief that good stewardship is good business.

As these characteristics gain recognition and are assigned value by the investment community, we expect them to become increasingly accretive to returns.

These attributes also add optionality in terms of land management practices and end-use markets, potentially expanding the investable universe and bolstering returns.

Timber is a natural, sustainable and renewable resource with an expanding set of demand drivers, including textiles, mass timber, paper packaging as a substitute for plastic, and the ability to generate high-quality carbon credits.

These developments enhance natural capital’s ability to positively contribute to global ecosystems, and provide additional opportunities to generate value from practices that support biodiversity, conserve water and mitigate risks.

Regenerative farming practices, precision agriculture, integrated pest management, water resource management, and continued innovation and technological gains can enhance sustainable farming practices and limit inputs and costs while restoring soil biodiversity and providing the potential to offer carbon sequestration benefits.

The trend towards natural capital represents an evolution in investment objectives that combines an existing financial investment case with action to combat climate change and nature loss, and support the health of global ecosystems while providing for the basic needs of a growing world population.

David Fortin is senior director for economic research on timberland and agriculture at Manulife Investment Management, and Zhang Weiyi is associate director, agricultural economics