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Trees: a Natural Inflation Hedge

Report: Systematic Strategies

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Stockholm (HedgeNordic) – Inflation rates may not be the same everywhere, but rapidly rising inflation appears to have become a more global phenomenon and problem. Both institutional and smaller investors are increasingly looking for inflation-protected investments to stay ahead of inflation and hedge against the erosion of portfolio value over time. A strong candidate to serve that inflation-protection role is forestry.

“In the current environment, inflation hedge is the one attribute investors need to look for when building up a portfolio,” confirms Jyri Hietala, a forestry-focused fund manager at Finnish asset manager United Bankers. “Historically, wood prices have been a good inflation hedge,” emphasizes Hietala. The inflation-adjusted price of wood has been stable for the past ten years, especially in Finland, according to the Helsinki-based portfolio manager. Perhaps more than many other commodities, timber has historically moved in tandem with the overall price level of the economy over the long-term.

Inflation Hedge

The inflation-hedging properties of forestry investments stem from the many uses of wood in the real economy, with wood used for fuel, building materials, furniture, paper, tool and more. “Derived demand for wood is dependent on the demand for its uses and the end products,” explains Kari Kangas of United Bankers. Higher demand – and thereby prices – for end products simultaneusly leads to higher demand for wood and higher wood prices, which makes timber a good hedge against the rising prices of goods and services. In addition to the price of timber, as a commodity, being closely related to changes in global demand, there has been another driver of higher wood prices this year.

“Logistics-driven and supply-side inflation due to the war in Ukraine has also driven wood prices higher,” according to Kangas. “Prices for roundwood are rising at the moment, perhaps not due to inflation only, but also because of the situation in Ukraine and what has happened to Russia’s export market of wood and end products,” elaborates Hietala. “The war and the associated consequences have changed the whole market, resulting in a scarcity of raw materials and end products, which, of course, led to increasing prices.”

“Even though inflation is very high, we expect the prices of roundwood and forest properties to increase more or less at the same rate as inflation.”

“Forest properties have also appreciated in value even more than the rate of inflation, with inflation running at a little over one percent per annum and the price of forest properties rising at an average of over three percent,” according to Hietala. “The current situation is quite different to what we have experienced in the past, because inflation is very high and rising very rapidly at the moment,” acknowledges the portfolio manager. “Even though inflation is very high, we expect the prices of roundwood and forest properties to increase more or less at the same rate as inflation,” considers Hietala.

Diversification

In addition to fulfilling the role of inflation protection, an allocation to forestry and timberland also provides diversification. “If we talk about portfolio theory, an allocatiion to forestry can be used to improve the diversification and risk-return profile of any portfolio,” says Kangas. “An allocation to forestry or timberland takes a portfolio to the efficient frontier,” the set of optimal portfolios offering the highest expected return for a defined level of risk. “Diversification is an important aspect of forestry investing,” corraborates Hietala, particularly in the current volatile market environment. These diversification properties stem from “the unique ingredients of forestry yield that are not correlated to any other asset classes or risk drivers,” according to Hietala.

“The unique ingredients of forestry yield that are not correlated to any other asset classes or risk drivers.”

One unique ingredient involves the biological growth of trees, which represents an integral driver of a forestry investment’s returns and the asset value of forestry assets. The return on forestry investments consists of two components: a direct cash flow return generated by the net earnings from forestry activities and an asset value growth that is determined by supply and demand for forestry assets, changes in the growing stock and its composition, among others. Therefore, the biological growth of trees affects both the direct cash flow return and asset value growth.

“The value growth does not only depend on the price increase of the land, but also from the biological growth.”

“The value growth does not only depend on the price increase of the land, but also from the biological growth,” explains Kangas. In Finland, the biological growth of trees has been around four percent on average over time. “Since we are active and professional managers in this space, we have to do a little bit better,” says the fund manager. “For example, UB Timberland Fund has enjoyed an annual total return of about 5.1 percent on average, of which a large share is comprised of the value appreciation of property holdings.” As Hietala explains, “most of the value growth comes both from the standing – and growing – stock, but also from the increased value of the timberland.” The assortment of trees also determines the value of forestry assets, according to Kangas. “There are different roundwood assortments, some more valuable than others.” Forestry assets, therefore, do not only increase in value due to volume growth but also due to moving into higher-priced wood-product categories.

In addition to the value growth, forestry investments also offer an annual net revenue realized return. “The main component of this revenue stream comes from selling roundwood,” explains Hietala. “That is the revenue-generation stream, but you also have costs associated with silvicultural and other activities that usually account for 10 to 15 percent of the revenue,” explains the fund manager. The portfolio-level cash flows can be smoothed or optmised through investor-directed management and harvest plan, resulting in a stable, secure and sustainable cash flow from forestry investments.

The ESG Debate Around Forestry Investments

The European Commission’s new EU forest strategy for 2030, which is part of the EU’s European Green Deal, has led to ongoing discussions and concerns around the topic of how forests should be managed and what their wood can be used for. “Sustainability is a multi-dimensional issue in forest management,” acknowledges Hietala. “With the EU Green Deal and the Fit-for-55 package, there are some positives,” says Hietala, as forests can act as carbon sinks – anything that absorbs more carbon than they release – and wood-based products are seen as renewable and climate-friendly raw material that substitutes energy-intensive materials and fossil fuels. “At the same time, under EU Taxonomy, for example, we expect there will be new regulation introduced to actual forest management practices focusing on protecting biodiversity,” according to Hietala.

“Sustainability is a multi-dimensional issue in forest management.”

“It is still too early to say what the actual criteria will be for forest management,” says Hietala. The clear-cutting technique where all trees in an area are felled may face restrictions, according to the fund manager. “There can, for example, be some kind of limitation either in terms of maximum areas that can be clear-cut or in terms of strictly protecting a percentage of the forest,” elaborates Hietala. As a large forest owner, United Bankers is well positioned to navigate future regulations due to their ability to identify areas to protect, for instance.

Moreover, sustainable forest management has always been an integral part of the timberland funds managed by United Bankers. “We aim for the highest, meaning that all of our timberland funds will be classified as sustainable investments as defined in the EU Taxonomy,” adds Hietala. Despite uncertainty regarding soon-to-be-implemented regulation, sustainable forestry management can offer great opportunities for green, ethical, socially responsible investing, as well as opportunities for accessing stable, inflation-protected return streams.

 

This article features in HedgeNordic’s “Private Markets” publication.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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