Timberland is becoming an increasingly popular addition to institutional investors’ portfolios. In an extract from PEI’s latest book The Definitive Guide to Investing in Timberland, Chung Hong Fu, a veteran timberland investor, explains why investors are turning to the niche asset class and what they should expect in terms of risk and return profile
The decision to invest in timberland inevitably comes down to how the asset class’s risk and return profile fits with an investor’s investment needs and expectations. However, other factors are increasingly becoming important to investors.
Some individual and institutional investors are attracted to timberland not only for its financial characteristics, but also for its potential to help them make socially responsible investments (SRI).
When managed correctly, timberland can be a logical fit for an investor’s “green portfolio”. However, investors who have aggressive SRI mandates also may require that their timberland portfolio managers conform to strong sustainability principles. This is often achieved through participation in third-party certification programmes. But the need for certification varies from market to market. Most industrialised nations, such as Canada, Germany and the US, have stringent environmental and forestry laws and regulations in place to maintain high standards of natural resource management. Certification tends to be more relevant for those investing in emerging markets, where environmental programmes can be more lax or unequally enforced. Certification helps convey a “stamp of approval” that high standards of environmental responsibility are being employed in the day-to-day management of their timberland portfolios.
The two leading forest certification standards with which SRI-conscious investors usually require compliance are those of the Forest Stewardship Council (FSC) and the Sustainable Forestry Initiative (SFI). The former is the leading global certification standard. The latter is prominent in the US, but it is accepted by the Europe-based Programme for the Endorsement of Forest Certification scheme (PEFC). Wide variations exist among investors on the issue of forest certification but, as a general observation, European investors are more likely than their North American peers to embrace SRI and green credentials. In Europe, investors from more environmentally conscious cultures, such as Germany and Scandinavia, tend to be at the forefront adopting green standards governing the management of their timberland portfolios.
In addition to considering its potential attributes as a socially responsible investment, investors that wish to participate in the timberland asset class must address the classic trade-off between its risk and return characteristics, which are unique. This is not a straightforward task because timberland is a complex asset. When building diversified and balanced portfolios of forest holdings, investors must understand the different risk and return variables associated with their investment strategies – and specifically with the various regions where they intend to own forest assets.
Table 1 illustrates the way in which timberland can range from lower risk to high risk. It also demonstrates the corresponding risk premiums that result from moving from established markets, such as the US and Australia, to emerging or pioneering markets, such as Latvia and Mozambique.
As shown in Table 2, investment style type also influences risk and return. A portfolio manager’s assessment of an investor’s risk appetite has a significant impact on the regions in which it will invest and the types of strategies that it will employ.
Of course, these risk and return perceptions are constantly evolving: timberland investments that are made in well-established markets can generally be tracked against well-documented return histories. So, as markets globalise, mature and become more transparent over time, they gradually become less risky. For example, markets that investors currently view as emerging, high-risk sectors, such as Central America and Southeast Asia, could come to be viewed as lower-risk regions requiring lower risk premiums over the next five years.
Obviously, timberland investors do not universally perceive risk in the same way. European investors, for example, are generally more comfortable than their North American counterparts when it comes to investing in Russia, Central Europe and Africa. This is largely because of their long and intimate histories of trade and commercial involvement in those regions. In Africa, the past history of colonial involvement by Western European nations – and the desire of those nations to sustain economic relations with African states – has fostered close investment ties. European investors as a group appear to perceive less risk in timberland investments in Eastern Europe or Africa than a US or Canadian investor typically would. By comparison, US investors may be more familiar with Latin America, New Zealand and Australia, given their trade and diplomatic links, so they may therefore view these areas as lower-risk destinations than other regions.
When reaching a decision to allocate capital to the timberland asset class, many investors target a total commitment of 1 to 5 percent of their total portfolio, with most investing between 2 and 4 percent. Most investors usually do not exceed those levels because they recognise that the timberland investment universe is measurably smaller in scale than other leading asset classes: compare global hedge fund assets, for example, which exceeded $1.6 trillion in the first quarter of 2010, according to Hedge Fund Research, with invested timberland assets, which had a total market capitalisation of just $40 billion to $60 billion.
Diversification to manage risk is another important consideration for timberland investors. They can achieve this by investing in a mix of both natural forests and intensively managed plantations. Other variables can also improve diversification, including climate, soil type, species and end-use markets. Tree species, their ages and the types of log and forest products that will be harvested for income can all have an impact on the volatility of a timberland portfolio.
These diversification considerations mean that investors with smaller amounts of capital to commit to the asset class may wish to consider participating in TIMO (Timber Investment Management Organisation)-sponsored commingled funds or through a fund of funds investment structure. Both vehicles typically have lower levels of minimum commitment than straightforward direct funds and they offer investors the ability to pool their capital with others, allowing them to achieve much broader diversification than would otherwise be possible. For separately managed accounts, most TIMOs encourage minimum commitments in the $100 million to $200 million range. In short, a dedicated portfolio of this size provides the flexibility to execute an investment strategy that ensures broad diversification in accordance with an investor’s unique risk and return objectives.
Chung Hong Fu is managing director, economic research and analysis, at Timberland Investment Resources, a registered investment advisor and private Timberland Investment Management Organization (TIMO) headquartered in Atlanta, Georgia.
More information on PEI’s book The Definitive Guide to Investing in Timberland is available at www.peimedia.com.