Natural capital: a distinct source of portfolio diversification

The insight

Institutional portfolios can hold a wide range of assets while remaining exposed to similar underlying return drivers. Natural capital’s returns are driven by biological growth, land productivity and environmental markets, giving it low correlation with a conventional portfolio. Our hypothetical modelling of a UK pension portfolio suggests that a 10% allocation to natural capital can improve risk-adjusted returns and reduce estimated losses in adverse scenarios.

Four structural drivers

• Demographic and economic growth
• Resource security and shorter supply chains
• Climate change and constrained supply
• Environmental policy and market development

The financial case

Low correlation to public equity and fixed income: Timber, in particular, compounds through biological growth largely independent of the market cycle.

Downside mitigation: Biological growth and land value compound through the cycle, and standing timber can be left to grow when prices are weak, so the assets tend to hold value when listed markets fall.

Inflation resilience: Revenues linked to physical output and policy pricing carry more inflation pass-through than nominal claims, giving a long-term hedge that conventional bonds lack.

What an optimal portfolio
allocation could look like

The practical question is not whether natural capital has attractive standalone properties, but what role it plays inside a diversified portfolio.

We assess this using a hypothetical UK pension fund with sterling liabilities as the benchmark – 35% global equities, 30% UK gilts, 10% UK equities, 10% US aggregate bonds, and 5% each in global infrastructure, UK REITs and US TIPS, and introduce a natural-capital allocation at progressively higher levels, funded proportionately across the benchmark so the effect of adding natural capital is isolated.

A blended allocation combines the complementary strengths of forestry, agriculture and nature markets, reducing dependence on any single asset or revenue stream.

The full paper sets out the allocation mix, methodology and detailed findings.

Tilting the mix by investment objective

A natural capital allocation mix can be tilted to the outcome an investor prioritises.

An income focus leans toward agriculture and nature markets, which carry the higher running yields; an inflation-protection focus leans toward forestry and agriculture, with their biological growth, land value and commodity pass-through; and a capital-growth focus concentrates further in forestry.

Across the allocations tested, our hypothetical modelling showed improvements across the portfolio measures assessed, with each sub-strategy contributing different strengths.

Why manager selection matters

Natural capital value is created through the acquisition, management and continual improvement of physical assets over long horizons. Soil, water, species, climate and local regulation all affect returns.

Manager skill therefore influences outcomes more than in most asset classes, and selection should extend well beyond track record to origination, underwriting, active management, governance and reporting.