Adding Wood To Your Portfolio - No Kidding

Are you interested in generating returns that consistently on-average beat the S&P 500, have a low correlation with other assets, and have low volatility of returns? Looking to get into the commodity markets, but worried that crude oil, natural gas, coal, and the soft food commodities have gotten ahead of themselves? No need to worry. We have the prefect investment for you - wood. No kidding, wood. And when I say investment, I mean investment. Waiting around for trees to grow is not for active day traders.

As reported by IndexUniverse, it turns out that timber investments have outperformed stocks, bonds, and commodities over the long run. In fact, the NCREIF Timberland Index, which is the standard benchmark for this asset class, increased 18.4% last year, versus a 5.5% rise for the S&P 500. Over time, the Timberland Index has beat all the major asset classes, except small-cap stocks. From 1992-2006, returns for timber were 12.2%. During the same time, large cap stocks returned 10.6%, small cap stocks returned 15.4%, international equities returned 8.2%, and corporate bonds returned 8.0%. When you consider volatility using the Sharpe Ratio, timber has the highest risk-adjusted returns, even beating small cap stocks (the Sharpe ratio for small cap stock was 0.63%, while reaching 0.84% for timber). Since 1987, the timber index has had only one down year in 2001 (-5.25%). During the same time frame, the S&P 500 has been down four times (as low as -22.10%).

Timber as an asset class also has a very low correlation to other asset classes given that its primary driver (biological growth) is not as affected by sub-prime woes, dot-com meltdowns, or the next Enron. The trees just keep growing. Also, with timber there is always the threat of physical damage (who among us has not seen a California wildfire on TV recently). Yet for a diversified portfolio, physical losses usually only decrease returns by 0.1% annually, on average.

What are the downsides? First, timber has been attracting more attention lately, so some investors have been paying up for assets. There is a lot of institutional and private money chasing a limited number of trees, at least those open to harvest and investment. Some investors are now even looking overseas. As with any investment, overpaying can certainly lower returns. Second, trees are not liquid investments given that much of their return requires patience. When you look at the profits from trees, about 61% comes from biological growth, with 33% from the price of timber, and 6% from land appreciation. Selling at the right time, and waiting for the trees to get big enough to command top dollar, are key. Patience truly is a virtue for timber investors.

So where to invest? George Nichols, who authored the original IndexUniverse article, does a great job outlining the pros and cons of current "timber" investments in an article located here. I put quotes around the word timber because, as Nichols points out, many proclaimed timber investments are not what they seem. Two popular timber ETFs are the Claymore/Clear Global Timber Index ETF (CUT) and the iShares S&P Global Timber & Forestry Index Fund ETF (WOOD). If anything, they have easy to remember tickers. The problem with these ETFs is that they do not provide investors with direct access to the timber asset class - which has all the return, correlation, and volatility benefits mentioned earlier. Each is broadly focused on forestry/paper stocks, such as International Paper (IP). Instead of investing in an asset class, investors end up investing in a sector, one of which ironically may suffer with higher raw material timber costs. According to Nichols, WOOD appears to be a little better than CUT for correlation to timber, primarily due to its REIT exposure (more below). Nonetheless, it is also still not perfect, or really that good as a timber pure-play.

An alternative to ETFs are timber REITs. Nichols mentions three in his article: Plum Creek Timber (PCL), Rayonier (RYN), and Potlatch (PCH). Plum Creek has 8 million acres of forests, making it the country's largest non-government owner of timberland. Unfortunately, like the ETFs, the REITs are also not pure-play timber companies since each has manufacturing operations, giving significant exposure to sawmills and paper mills. Of the three mentioned, Plum Creek Timber has the highest timber exposure (71%), yet still suffers a low correlation to timber. Nonetheless, it is expected that correlations will increase in the future as firms continue to divest manufacturing assets, giving the funds a higher pure-play timber focus. Potlatch recently announced that it was spinning-off its pulp-based businesses.

So what to do? Nichols believes that in theory timber is an attractive asset class that should be considered as part of a portfolio. Unfortunately, in practice, getting some timber in your portfolio is more easily said than done. Of the group, PCL is the most attractive, even if not a perfect proxy for timber. Waiting for more divestment of manufacturing operations from each of the REITs may be necessary to fully see the benefits that timber investment offers. Who ever thought wood could be this profitable, and for that matter, so difficult to buy?

(Note: For those interested in more details beyond this summary, please refer to both articles written by Nichols. Each is well written and researched, providing both the pros and cons to timber investment, along with data to support his conclusions.)