Tony Dalwood: Natural capital is still an under-institutionalised area
Back in 2022, rising interest rates revealed an unfortunate truth about institutional portfolios. Despite the growing popularity of alternatives like infrastructure, private equity and real estate, portfolios were far less diversified than previously thought.
The wide range of different asset classes now represented in pension funds do not necessarily translate into meaningful diversification because their underlying drivers of returns are often the same as those that affect traditional equity and bond markets.
For pension funds searching for truly uncorrelated assets, natural capital – the world's stock of natural assets like forests, soil and land – offers a genuinely different source of financial return.
Demand drivers
Natural capital's value is anchored in biological growth, land and the growing monetisation of ecosystem services. It also benefits from structural tailwinds, with population growth, urbanisation and rising consumption increasing demand for food, timber and other renewable materials.
A fragmented geopolitical environment is also increasing the strategic importance of secure and resilient sources of essential commodities, while environmental policies continue to drive demand for carbon sequestration and ecosystem restoration. These drivers have contributed to a long track record of returns, with forestry and agriculture delivering historical annualised returns of 7.7% and 12% respectively*.
Importantly, natural capital offers a unique form of downside mitigation. Standing timber can be left to grow when prices are weak and harvested when they recover, so the assets tend to hold value when listed markets fall. A tree keeps growing whether or not it has been a good year for public markets.
Diversification data
The figures bear this out. Measured against a diversified UK portfolio from 2000 to 2025, forestry correlates at +0.24 and agriculture at +0.31. Carbon, on a shorter 10-year record, is negative at -0.42*.
The impact of these differentiated, competitive returns on a wider portfolio is striking.
We modelled a hypothetical UK pension fund holding 35% global equities, 30% UK gilts, 10% UK equities, 10% US aggregate bonds and 5% each in global infrastructure, UK REITs and US TIPS. Adding a 10% weighting to natural capital, the Sharpe ratio improved by 7.4% and the Sortino ratio by 32.5%, while the diversification ratio rose 7.2% and equity beta fell 13%.
Measured across four objectives, the optimal natural capital allocation lands between 19% and 24.5%. I do not expect many trustee boards to go anywhere near that, but the good news is that the benefit to portfolios is heavily front-loaded – a 10% allocation captures 64% of the average maximum improvement.
Classification conundrum
UK schemes almost invariably hold natural capital within real assets, alongside property and infrastructure. That is a reasonable home, and the long duration matches long-dated liabilities well. Conversely, Canadian funds more often position natural capital within a dedicated natural resources allocation.
However, the precise makeup of a natural capital allocation will depend on the outcome an investor is prioritising. Those focused more on income may lean more toward agriculture and nature markets, which carry higher running yields, while investors seeking inflation protection or capital growth may concentrate more on forestry.
From a tiny seed
For now, this is still an under-institutionalised area. The global forestry market is estimated at around €370bn (£313bn), of which only about €108bn is under institutional ownership, leaving material room for allocation growth. Alongside forestry, agriculture is by far the largest physical market, yet only a small fraction is under professional management. Meanwhile, nature markets – far newer and smaller – are the fastest growing; the voluntary carbon market is worth a few billion dollars today but is projected to reach tens of billions by 2030, while biodiversity markets are still emerging from a low base.
Despite its long-term tailwinds, natural capital cannot be a passive investment. Value in natural capital is created through the acquisition, management and continual improvement of physical assets over long horizons, so manager skill influences outcomes here more than it does in most asset classes.
For allocators, natural capital should not be treated simply as another real asset, but as a distinct source of diversification with the potential to improve resilience and broaden exposure to the physical economy.
Tony Dalwood is chief executive at Gresham House
Note: * Returns, volatility and correlations are desmoothed (Geltner 1993), converted to GBP and James-Stein-shrunk; forestry and agriculture from the NCREIF Total Timberland and Total Farmland indices, carbon from CA/WCI compliance prices, benchmark data via Bloomberg, cross-checked against Cliffwater's 2026 Asset Allocation Report.
