The role of timberland in a portfolio

Nobel Prize Harry Markowitz is credited with saying that diversification, which is risk reduction through portfolio construction, is the “closest thing an investor can get to a free lunch”. A logical conclusion from this statement is that in fact diversification is not really free. Indeed, proper diversification requires knowledge, time and hard work.

More provocatively, one could wonder if free lunches – or their financial equivalent – are a good thing at all. They could lead to overeating, which over the long term has the same detrimental and lethal effect as starving. This is also true of under- and over-diversification. Concentration, just like starving, is well known. Investors are exposed to idiosyncratic risks associated with single assets. A typical illustration is geographical concentration.

More provocatively, one could wonder if free lunches – or their financial equivalent – are a good thing at all. They could lead to overeating, which over the long term has the same detrimental and lethal effect as starving. This is also true of under- and over-diversification. Concentration, just like starving, is well known. Investors are exposed to idiosyncratic risks associated with single assets. A typical illustration is geographical concentration.

Excessive diversification, like overeating, is a risk that has only recently been acknowledged. Over-diversification can lead investors to reduce their returns with only marginal (or no) risk reduction. Increased costs associated with product selection and management, as well as compliance, is an immediate consequence. Over-diversification might also lead to a dilution of returns. The risk is of lower long-term average returns.

The purpose of diversification is to optimize the risk-return profile of investment portfolios, not to systematically lower their prospective returns. Striking the right risk-return balance can prove to be difficult. Markowitz defined the process of portfolio optimization as a mean-variance analysis, which crucially assumes that assets are liquid. As less liquid assets, private equity, private debt and private real assets cannot easily be integrated in this framework. Running correlation or covariance tests between more and less liquid assets can prove to be particularly challenging. This top-down approach has yet to be successfully accomplished.

An alternative bottom-up approach, which is more incremental, is to test each asset to see if it introduces a valuable diversification effect. For this issue of FrontLine, we capitalize on Pevara’s high quality data to illustrate this idea with a single asset: timberland. The idea is to compare this asset with others in terms of risks and returns. Although rather simple on paper, this approach requires a rigorous comparison. To be scientifically correct, it would require like-for-like time periods, with significant data points collected in different contexts (recession, crash, boom and growth period). We are not attempting such in-depth analysis here, but rather to provide a first illustrative approach.

Table 1 – IRR of funds of funds, timberland, core real estate and brownfield infrastructure funds