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As investors have become more and more educated on the advantages of ETFs over traditional actively-managed mutual funds, billions of dollars have flowed into these funds, and ETFs have evolved from a cult following to a mainstream investment vehicle. Driven by the success of “plain vanilla” ETFs that offer exposure to well-known, broad-based equity and bond indexes, ETF issuers have expanded their product offerings to provide investors exposure to nearly every corner of the investable market. While many of these ETFs cover sectors such as technology and financials, others, such as timber ETFs are far less traditional. But these funds may still be a valuable addition to many portfolios.

Due to significant barriers to entry and high capital costs, investments in timber have historically been only available to institutional investors. And while timber seems like an unusual place to park one’s assets, it is a popular investment choice among university endowments and pension funds. With the advent of the ETF industry, multiple funds have popped up offering average investors to this once forbidden investment:

  • Claymore/Clear Global Timber Index ETF (NYSEARCA:CUT): This fund tracks an index comprised of companies that own or lease forested land and harvest the timber for commercial use and the sale of wood-based products, including lumber, pulp, paper, and packaging. CUT has approximately 30 holdings in ten different countries.

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CUT Offers Global Exposure to Timber

  • iShares S&P Global Timber & Forestry Index Fund (NASDAQ:WOOD): WOOD tracks the S&P Global Timber & Forestry Index, a benchmark comprised of 25 companies engaged in the ownership, management, and upstream supply chain of forests and timberlands. Stocks in this ETF include REITs, forest products companies, paper packaging companies, and agricultural products companies.

WOOD Maintains Relatively Low Correlation With Traditional Asset Classes

Diversification Benefits

Timber is appealing to institutional investors primarily because of its low correlation with other asset classes, meaning that it is an effective means of achieving an appropriate level of diversification within a portfolio. Over the last 15+ years, the Dow Jones World Forestry & Paper Index has shown the following correlations to major asset classes:

Asset Class Correlation
Bonds 0.03
International Equity 0.76
Domestic Equity 0.69
REITs 0.55
Commodities 0.20
3-Month T-Bill 0.08

In addition to its valuable diversification characteristics, timber is attractive to long-term institutional investors because it is in relatively stable demand (timber demand has historically tracked population growth), meaning it generates a stable return to investors. And unlike agricultural investments, harvesting of timber is flexible, allowing landowners to delay sales if prices are temporarily low. Moreover, timber has historically been positively correlated with inflation, generally providing a return 300 to 800 basis points above the increase in price levels. This characteristic may be particularly valuable for investors concerned about the long-term impact of the massive injections of cash into the economies of several developed nations. Finally, timber investments may offer some tax advantages, including favorable capital gains treatments on harvest sales and benefits related to the depletion allowance.

Risks

Timber ETFs, of course, are not without their risk factors. Among the largest is the potential for devastation related to natural disasters, including fires, tornadoes, hurricanes, and pest infestations. Although the loss ratio for the industry is low (historically less than 1%), a single event can potentially have a large impact. Timber companies may also face significant pressure from political and regulatory groups, although this is generally not a major issue beyond the U.S. Moreover, timber demands can be impacted by a number of macroeconomic factors, including housing starts and prices of substitutes (such as steel).

Timber ETFs aren’t for everyone. But for investors looking to add assets that maintain relatively low correlations with traditional asset classes (particularly bonds), or for those looking for additional ways to add an inflation hedge to their portfolios, these funds may be worth some consideration.

Disclosure: No positions at time of writing.

Source: CUT vs. WOOD: Timber ETFs Square Off