Manulife on expanding the efficient frontier with agri

The investment characteristics of timberland and agriculture offer a compelling rationale for inclusion in larger multi-asset portfolios, says Manulife Investment Management’s David Fortin and Weiyi Zhang.

This article is sponsored by Manulife Investment Management

Timberland and farmland are attracting increasing investor attention, particularly given their potential to positively impact the environment while augmenting returns generated from traditional management.

David Fortin, Manulife
David Fortin

Their historical investment performance and interaction with other financial asset classes suggests that inclusion within multi-asset investment strategies can achieve the financial objectives of long-term investors by offering competitive risk-adjusted and long-term stable returns, enhancing portfolio diversification and preserving capital.

Our experience of sustainably managing timberland and farmland assets has taught us that protecting and promoting healthier and more diverse ecosystems can enhance their long-term capability to generate competitive returns. Good stewardship is good business and can positively impact communities through compelling employment opportunities, efficient water resource management, third party-certified land management practices and technological innovation to effectively protect healthy ecosystems while also meeting clients’ financial goals.

The inherent characteristics of sustainably managed timberland and farmland that can help address the global challenges of climate change, nature loss and rising inequality are increasingly assigned tangible value that adds optionality to land management, increases the investable universe and is accretive to returns.

Complementary investment attributes

Weiyi Zhang, Manulife
Weiyi Zhang

Timberland and farmland are attractive long-term investments that have historically delivered capital preservation and competitive risk-adjusted performance alongside stable cash yield and long-term appreciation. Additionally, they have provided potential to diversify investors’ broader investment portfolios and hedge against inflation.

Timberland investments provided average total annualized real US dollar returns (net of inflation) of nearly 7 percent and nominal returns of 9 percent between 1991 and 2022, as represented by the Timberland Property Index of the National Council of Real Estate Investment Fiduciaries (NCREIF). Over the same period, total real returns for investments in farmland averaged 8 percent, or nearly 11 percent on a nominal basis, as reported by NCREIF’s Farmland Property Index.

In addition, timberland and farmland have performed well on a risk adjusted basis over the last 25 years, as measured by the Sharpe ratio. At 1.47 and 0.91, respectively, farmland and timberland compare favorably against most traditional financial assets. When timberland and farmland are combined in a hypothetical 50/50 allocation, the resultant pro-forma natural capital portfolio would have produced a favorable Sharpe ratio of 1.30 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 correlation with other traditional financial assets. Meanwhile, timberland and farmland returns have maintained an average correlation of approximately 0.77 with each other over the past 20 years. The positive, but not perfect correlation, is 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.

“Timberland and farmland can play a role in improving the overall performance of a mixed-asset portfolio through diversification”

Additionally, our timberland and agriculture investment strategies include diversification within each asset class across regions, timber species and age-class, crop types, end-products and markets to help mitigate risk from weather, pest, disease, natural disaster, and both macroeconomic and market-specific factors.

Compelling market fundamentals

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

This growing demand is juxtaposed by 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 timberland in the most efficient and environmentally sustainable manner, utilizing 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. During periods with weak market conditions, timberland owners can defer their harvest operations and allow their trees to grow in both volume and value, including their carbon value potential as their carbon sequestration capabilities are now more explicitly valued, providing additional optionality in certain timber production regions. Meanwhile, scientific and technological advancements in genetics and silviculture can increase yield while mitigating risks from extreme weather, natural disasters and disease.

Farmland productivity gains are also crucial to meet growing demand from an increasingly limited area of available arable land. New advances in genetics and agronomy are sustainably improving crop 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 soil’s potential to store carbon.

The enduring theme of finite natural resources, managed sustainably to meet the increasing needs of a growing population with rising income, will continue to be a long-term fundamental demand driver for natural capital investments.

Constructing an efficient frontier

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 percent for a 50/50 timberland and farmland investment, utilizing data from the NCREIF.

Click to enlarge
Click to enlarge

The second chart shows the results of this analysis. The lines represent the efficient frontiers – the theoretical collection of all possible optimized combinations of asset class allocations within a given portfolio – with and without timberland and agriculture.

The inclusion of timberland and farmland can potentially improve the risk-return profile by shifting the efficient frontier upward 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 USD-based return of 7.4 percent, compared to 7.3 percent for the optimal portfolio without them, but with much lower risk. As a result, the Sharpe ratio of the optimal portfolio improves from 0.57 to 0.96 after the inclusion of timberland and farmland, a 68 percent 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.

Rising focus on natural capital

In addition to the benefits of improved financial performance, the rise in interest and importance of natural capital is illuminating the social and environmental benefits inherent in 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.

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

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.

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

The inclusion of timberland and farmland in mixed-asset investment portfolios has been proven to provide traditional financial benefits, including enhanced risk-adjusted returns while inherent ecosytem benefits are increasingly assigned value, adding optionality and augmenting traditional returns.