A 10 per cent allocation to natural capital could improve a range of risk-adjusted performance and diversification measures for a typical UK institutional portfolio, according to modelling from Gresham House.

In its latest paper, Natural Capital: A distinct asset class and source of portfolio diversification, Gresham House examined the effect of introducing natural capital into a hypothetical UK pension fund portfolio over the period from 2000 to 2025.

The benchmark portfolio comprised 35 per cent global equities, 30 per cent UK gilts, 10 per cent UK equities, 10 per cent US aggregate bonds and five per cent each in global infrastructure, UK real estate investment trusts and US Treasury inflation-protected securities.

According to the modelling, adding a 10 per cent natural capital allocation improved the portfolio’s Sharpe ratio by 7.4 per cent and its Sortino ratio by 32.5 per cent, while increasing the diversification ratio by 7.2 per cent and reducing equity beta by 13 per cent.

Gresham House noted that natural capital offered different return drivers to traditional equities and bonds, with performance linked more closely to biological growth, land productivity and environmental markets than to interest rates, liquidity and short-term market sentiment.

Measured across four objectives - the Sharpe ratio, diversification ratio, equal risk contribution and portfolio variance - the research suggested an optimal natural capital allocation of between around 19 per cent and 24.5 per cent.

However, Gresham House acknowledged that much of the potential benefit was captured at lower allocations, with a 10 per cent weighting achieving 64 per cent of the average maximum improvement across the measures examined.

This rose to 86 per cent at a 15 per cent allocation and 97 per cent at 20 per cent.

The asset manager therefore described around 10 per cent as a “pragmatic” entry point, balancing diversification benefits against deployment, liquidity and concentration constraints.

Within a natural capital allocation, Gresham House proposed an illustrative base case of around 65 per cent sustainable forestry, 25 per cent agriculture and 10 per cent nature markets, including carbon and biodiversity credits.

It said the mix could then be adjusted depending on an investor’s objectives, with greater allocations to agriculture and nature markets for income, forestry and agriculture for inflation protection, and forestry for capital growth.

The research also highlighted the relatively low level of institutional ownership across natural capital assets.

Gresham House estimated the global forestry market at around €370bn, of which approximately €108bn was held by institutional investors.

Meanwhile, global farmland represents a multi-trillion-dollar physical market, but only a small proportion is professionally managed.

The voluntary carbon market, currently valued at a few billion dollars, is projected to grow to tens of billions by 2030, while biodiversity markets, including the UK’s Biodiversity Net Gain regime, are also beginning to develop.

The paper also identified differences in how institutional investors classify the asset class, with UK, US and Australian institutions generally placing natural capital within real assets alongside property and infrastructure.

Canadian institutions are an exception, tending to use a dedicated natural resources allocation, which Gresham House said could affect how investors approach individual components such as forestry, carbon and biodiversity.

Gresham House forestry managing director, Olly Hughes, said: “Allocators have added numerous asset classes in recent years, but in many cases they have ended up holding the same risks.

“While portfolios still rise and fall on rates, liquidity and sentiment, natural capital is different - a tree keeps growing whether or not it has been a good year in markets.”

He added: “A 10 per cent allocation captures about two-thirds of the benefit available, so this is a realistic starting point that brings diversification benefits without requiring a wholesale rebuild of a portfolio."

However, Gresham House stressed that natural capital carries a distinct set of risks, including climate and weather exposure, commodity prices, regulation, illiquidity, currency movements and manager execution.

It argued that these risks could be managed through geographic and asset diversification, conservative underwriting, insurance, active management and appropriate governance, while highlighting manager selection as particularly important given the operational nature of the asset class.

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