CUT vs. WOOD: Timber ETFs Square Off

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 (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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• iShares S&P Global Timber & Forestry Index Fund (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.

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.

Comments

[Geoffrey Lordi:]

The problem with CUT & WOOD is that they don't track timber, per say, but timber and paper companies, as the index states. A .76 correlation to MCAFE and a .69 to (I assume, based on your statistics) the S&P or equivalent - even over 15 years - is not a low correlation value. In fact, both of these ETFs have traded in near lockstep over most major measurement periods since their inception.

I certainly do not disagree with the premise of owning timber, and our neutral fund regularly invests in highly non-correlated assets. But raw land, for those inclined, gives folks an (arguably) better non-correlated appreciation than these two, largely mainstream, equity trackers. Even Plum Creek (PCL) - a favorite of fellow portfolio builder R. Nusbaum - exhibited a .91 correlation to the S&P over the last year, with WOOD at .99 and CUT at .96.

Jul 01 11:27 AM

[Mad Hedge F...:]

It's still a great sector to follow. There’s nothing like getting up in the morning, taking off your shirt, and splitting a quarter cord of wood to get the blood flowing. I seem to be the only one out there who likes the knotty, aromatic commodity (see madhedgefundtrader.com...). The real reason is that we are crawling off of a five year bottom; we have miles to go before we approach a decade high of $4.60, and that lumber is still inherently cheap. What will happen when the Chinese start buying? They’ve bought everything else. One of the tip offs that you’ve got a great position is that all of the accidents and surprises tend to happen on the upside.

Jul 01 11:34 AM

[Bob Mayo:]

CUT and WOOD seem more like sectors of the business world than an investment in an alternative asset class consisting of timberland. What about Cambian Global Timberland, trading in London? Any opinions?

Jul 01 05:26 PM

[Roger Nusbaum:]

Geoff, thanks for the mention.

Bob, there are a bunch of products similar to Cambian out there. There are several that trade in Canada and a couple in Australia, I seem to remember one of the Aussie listed products going bust very recently. As much as I wish this were not true, most of these products don't really capture buying a bunch of timber land in NZ, Canada or Scandanavia.


On Jul 01 05:26 PM Bob Mayo wrote:

> CUT and WOOD seem more like sectors of the business world than an
> investment in an alternative asset class consisting of timberland.
> What about Cambian Global Timberland, trading in London? Any opinions?

Jul 01 06:18 PM

[donzelion:]

Concur with Geoffrey's comments above. In addition, I'd pause on this point: "Timber companies may also face significant pressure from political and regulatory groups, although this is generally not a major issue beyond the U.S."

Outside the U.S., the political risks can be even more extreme depending on the country or region in question (esp. issues with respect to taxes and export controls). And don't neglect other risks (esp. various termites, bark beetles, and other bugs that can destroy the value of timber assets for long periods of time).

Don't get me wrong: I like the notion of investing in timber, and the risks aren't particularly extreme, but they're quite real.

Jul 02 09:12 AM

[Alan Young:]

Mr. Johnston is way off base when he says the ETF offers entry to this "once-forbidden" sector; all their holdings are publicly traded companies, and there's nothing difficult about owning timberland via WY, PCL, or PCH. But, as other comments have noted, that is certainly not pure-play forestland ownership. You have to go to private equity for that.

The proposal to make forests a haven for carbon-offset investment makes this asset class even more attractive, so possibly other investment vehicles will appear to fit the demand.

Jul 02 11:31 AM

[HardwoodFlo...:]

I cannot tell you how bad these insitutional investors are for what was once a great long term investment.The ETF is just the end-game for this sector.

There are people playing in this sector that have no business in it. These ETFs only create uncertainty and a propensity for wild swings in a market that has traditionally been stable.

Jul 02 12:30 PM

[George Nichols:]

I respectfully disagree with your assessment, Michael. I've written extensively about timber investing (and calculated correlation stats) on Seeking Alpha (see my profile), and in greater detail at my site: tinyurl.com/64cnhe.

You made the common error of conflating the two unrelated concepts of: 1) timberland as an asset class (i.e. what Harvard and Yale have owned) and 2) sector bets via forestry stocks.

The stark differences in their downside-correlation profiles were shown in 2008. The NCREIF Timberland Index generated positive returns, while CUT plunged roughly 48.7%.

It's an apples-to-oranges comparison that retail investors often make, which unfortunately causes them to lose their shirt.

Speaking of which, the news Roger is alluding to is the recent high-profile collapse of Australian entities Great Southern Group and Timbercorp. Many retail timber investors were largely wiped out.

The author's assertion that retail investors now have access to this formerly "forbidden" asset class is highly premature.

Jul 04 11:21 AM

[TradingHelp...:]

Good article, thank you. SA is proving to be the leading site for finding out about these non-mainstream sectors.

Jul 04 12:45 PM