Want a natural alternative asset? Invest in a tree
Our multi-asset funds are investing in trees. Next time you receive a fund update, you might just see a leaf in our presentations.
Followers of the blog and investors in our funds will know that we use listed alternatives such as REITs and Infrastructure to improve diversification. Our latest addition to the band of listed alternatives is forestry. In this slightly longer than usual blog, I define the asset class, look at its characteristics and also cover how we implement this asset class in our portfolios.
Start with the roots
Let’s start by defining the asset class. What does it mean to be invested in forestry? We define investment in forestry as investing into timberland companies, which own forests and the associated lands as their main assets. As such, success of these companies depends on their ability to manage their resources in a sustainable way.
When we consider drivers to return, similar parallels can be drawn with real estate. Drivers of return for forestry can be broken down into two: growth in value of the asset, timber, and secondly growth in value of the land on which the asset sits on. Over the very long term, both tend to keep up with inflation, making forestry a real asset.
Starting with land value, a larger forest tends to lead to higher land values. But when dealing with a natural asset such as forestry, there is also a big emphasis on the health of the forest. Healthier forests improve the quality and yields for timberlands. When looked at it this way, there is natural alignment between care of forests and a timberland’s success. Timberland companies are incentivised to ensure sustainable management of their land.
Now let’s consider factors that drive the value of the asset. This leads us to a unique component of the asset class. The value of timber grows over time, independent of economic cycles, as the trees grow larger in size and number. This independence to the economic cycle, and dependence to time, gives the asset class unique trait over other listed alternatives.
There is an added element of differentiation, via optionality in harvesting which also acts as a support for timber values. Generally speaking, there is a minimum age, but not much of a maximum age before a tree can be harvested. As such, timberland operators can optimise when to harvest trees, usually choosing to do so when prices are favourable.
Timbers are processed into wood products, such as lumbers and wood panels, raw materials for homebuilders, and pulp to produce paper and tissue. Demand and supply dynamics for these wood products acts as an additional component to the overall return from timber.
Demand tends to follow economic activity closely. For example, as homebuilding activity increases so does the demand for lumber or as e-commerce picks up, demand for packaging and thus pulp increases. Demand is not a one way street however. The move from paper to digital content has resulted in a structural decline in paper demand. Demand has also been affected by the recent trade war between the US and China. Many of the established and larger timberland firms are based in the US, with exports to China. Lumber exports fell as the trade war increased global growth uncertainty.
Supply on the other hand is driven by the optionality in harvesting, as described above, but also by natural factors such as wild fires or pine beetle infestation. To give you an idea of the impact of the latter, for instance in British Columbia, pine beetle infestation has affected more than 18 million hectares of forest. According to the Government of British Columbia, this equates to 58% pine volume, and is the main reason why supply from Canada has been restricted.
Mixing trees with other asset classes
[chart 1 here]
Source: Bloomberg, LGIM.
Put all of this into the context of historical returns, we find that over the long term forestry has lagged wider equity markets. Is this a bad thing? Not necessarily. Similar to other listed alternatives, forestry has a lower beta to equities. What is the price of lower beta? As we can see from the line chart, it would underperform equities in periods of positive performance but on the flip side, can outperform in periods of negative performance. For example, from peak to trough of the global financial crisis, forestry outperformed broader equities by circa 10%, offering investors better downside protection. A similar dynamic was also at play during dot-com bubble in the early 2000s.
[chart 2 here]
Source: Bloomberg, LGIM.
It isn’t just the lower beta characteristic that roots us into this asset class. Forestry also exhibits low correlation and betas to our other listed alternatives, which mean the addition into our portfolios improve the overall diversification.
How we do it
A common way of investing into the asset class is through private investment vehicle options. These offer a more ‘direct’ exposure and don’t show as strong an equity linkage (though that may just be a result of the pricing approach). However, the drawbacks are very low liquidity and a long investment period (8 to 15 years).
For those that prefer more liquid options, there is the choice of forestry ETFs and active funds. Both invest in timberland companies but also in other companies further along the timber value chain, such as paper and packaging companies. As a result, investors will also be exposed to more cyclical factors, which can offset the timberland exposure they seek.
There is also the option of investing directly in the timberland companies, which is our preferred choice for our funds. In our opinion, this offers us a better, more direct exposure to forestry as well as control over the companies that we want exposure to. Compared to private vehicles, this option will have higher volatility in the short term but we expect over the long term, the overall return to be broadly similar as the underlying exposures are the same.
A growing tree is for the long term
Trees are a renewable resource that offer a sustainable solution to many products that the world demands. Responsible management of forests doesn’t just protect the trees, but the wildlife and ecosystems that depend on it. It takes somewhere between 20 to 30 years for a tree to mature. Investing in forestry is for the long term.