How the sector has performed over the long run, compared to stocks, bonds and commodities.
Timber products touch our lives on a daily basis, though few people have ever considered timber as a potential investment. That is gradually changing, however, as more investors discover the little-known fact that timber investments have generally outperformed stocks, bonds, and commodities over the long run.
How Timber Makes Money
The defining attribute of timber is its steady, long-term biological growth. A tree's wood volume tends to increase 2% to 8% annually (varying by climate, species, and age). Compounding the effect of this biological growth, trees yield price gains when they grow into bigger product classes. For instance, a small tree that is only suitable for paper products may eventually grow into sawtimber, where it can fetch dramatically higher prices per ton and be used for products such as plywood or telephone poles.
An academic study found that biological growth drives more than 60% of total returns, while timber price changes and land appreciation account for the remainder of returns.
Returns And Volatility
The NCREIF Timberland Index, the standard benchmark for this asset class, increased 18.4% in 2007, versus a 5.5% rise for the S&P 500. Longer term, the Timberland Index has outpaced all the major asset classes depicted in the above graph (from Forest Investment Associates), except small-cap stocks. After factoring in volatility (as reflected in the Sharpe Ratio), timber has exhibited the highest risk-adjusted returns of the group. Timber returns have been particularly high over the past couple of decades, as illustrated in the second graph.
Relative to the S&P 500, timber has exhibited low downside risk. Since its 1987 inception, the NCREIF Timberland Index has declined only in one year: -5.25% in 2001. By contrast, the S&P 500 has fallen four times, including -22.10% in 2002.
Diversification, Correlations And Inflation Hedges
Timber can also improve a portfolio's risk-adjusted returns by virtue of its fairly low correlation to most asset classes. This low correlation reflects the fact that the primary driver of returns—biological growth—is unaffected by economic cycles.
Correlation statistics have varied greatly depending on the time period, as you can see from the graphs below by Jack Lutz of the Forest Research Group. While the 1960-2006 numbers give an idea of long-term results, pre-1987 returns are based on a simulated index rather than actual returns, so post-1987 figures may give a better indication of what to expect in the future.
Timber also exhibits a moderate correlation to inflation, and research indicates timber assets may serve as a good long-term hedge against unanticipated inflation.