Portfolio construction for Natural Capital portfolios

Introduction

We are profoundly dependent on ecosystems and the natural world, making the preservation of biodiversity critical not only for a well-functioning socioeconomic environment but also for the long-term development of humanity. Addressing the climate crisis cannot be achieved without rethinking our relationship with nature; biodiversity is not only essential to the energy transition to net zero but also plays a vital role in building the resilience needed to adapt to a changing climate. Data, methodologies, and research on biodiversity-related investing remain limited, but we do know that there are already numerous meaningful ways to allocate capital toward mitigating biodiversity loss and to engage with companies on biodiversity-related issues, ensuring that investors can be part of the solution today.

As more asset owners consider how to allocate to what is a nascent asset class, we share here some thoughts on how to build a portfolio. In so doing, we also address some of the subtleties that have presented themselves throughout our research to date.

The Natural Capital universe

As part of our Natural Capital research within our Alternative Solutions team we have met with over 40 managers. An increasing range of Natural Capital strategies are available, covering many disciplines across many geographies. Over the past five years, we have been expanding our in-house knowledge on this topic and have also made several investments, including seeding a new fund focused on biodiversity loss.

While the quadrant framework below¹ highlights impact and return as key decision factors, investors must also account for risk as an equally critical dimension. For example, whilst emerging market strategies (e.g. regenerative agriculture in Latin America) may offer both high return potential and significant positive impact, they also carry heightened governance, legal, and contractual risks. Alternatively, strategies like sustainable timber may provide outcomes with greater stability and lower volatility.  In practice, balancing risk alongside return and impact is essential to building resilient and diversified exposure to Natural Capital.

Source: Fulcrum Asset Management, for illustrative purposes only.

Introducing the concept of “Reflexivity”

According to the Thinking Ahead Institute, reflexivity refers to how investor beliefs and actions can influence asset prices, which in turn can change the fundamentals, and even how collective action can influence the future trajectory of issues like climate change.

Framing the investment rationale for Natural Capital can be tricky. The standalone investment case, when assessed purely on financial returns, can often appear “light” compared to other asset classes. This is partly because many Natural Capital projects prioritise long-term ecosystem resilience, biodiversity restoration, or carbon sequestration — outcomes that generate a public good but limited short-term cash flows. In addition, returns are often constrained by the biophysical limits (and competing interests) of land and nature-based systems, debate on the valuation of nature, regulatory uncertainty, and the need for patient capital. There is also a legitimate question around how much money one ‘should’ make out of these types of opportunities (e.g. generating a profit from food production through a private equity style strategy). So, perhaps it is worthwhile thinking of it in a different way and bringing in the concept of reflexivity.

In simple terms, a resilient natural environment, over the long run, should intuitively create more fertile ground (excuse the pun!) for other industries and companies to flourish; your overall portfolio should benefit. This positive feedback loop is not just indirect but also direct. For example, investing in regenerative practices often improves financial stability over time or a healthier ecosystem can reduce input costs from floods and droughts.

More than 50% of global GDP is moderately or highly dependent on nature and the services it provides². Scientists warn that we have crossed safe planetary boundaries for biodiversity – six of the nine cited critical Earth system limits (including biosphere integrity) are already transgressed³. This degradation is evident in increased water scarcity, pollution, and soil erosion, which in turn threaten food security and public health. Crucially, biodiversity loss and climate change are interlinked crises: intact ecosystems serve as carbon sinks and natural buffers (mangroves, forests and wetlands store carbon and shield communities from floods and droughts), while climate instability accelerates species and habitat loss⁴.

In short, protecting biodiversity is not only critical for climate mitigation and adaptation, but also for long-term economic and balance sheet resilience given that Natural Capital underpins productivity, stability, and future growth. The Dasgupta Review on the Economics of Biodiversity has been particularly informative during our research. The research refers to biodiversity loss as an asset management problem. “Biodiversity is akin to the complementarities among inputs in factory production, meaning that all inputs are significant in production. Second, biodiversity plays the same role in natural capital as diversity does in financial portfolios: it reduces variability (uncertainty) in yield.⁵ ”

More generally two challenges spring to mind around the concept of reflexivity in Natural Capital:

1. We can’t know the counterfactual: It will be difficult to subsequently prove that sensibly implemented Natural Capital strategies have improved the outcomes for your broader portfolio.
2. The “free rider” problem: The free rider problem arises because the benefits of natural capital investments are diffuse and widely shared, while the costs accrue to the investing entity. This links more broadly into the universal ownership mindset, where fiduciary duty sits both at the portfolio and wider stakeholder levels. If a Natural Capital investment offers a lower return than, say, a collection of venture capital tech investments, can we just leave the Natural Capital project for someone else to do? This strikes at the very heart of a challenge faced by responsibly minded investors everywhere. We offer some thoughts on how to ‘package’ investments later, but ultimately this dilemma sits with the asset owner decision maker.

Large, diversified, and long-term “universal owners” naturally internalise the externalities across their portfolios, as revenue from one asset or sector can create costs elsewhere. Systemic risks such as climate change and nature loss cannot be diversified away. The Covid-19 pandemic, likely triggered by zoonotic spillover, revealed how nature loss can disrupt the global economy. Ongoing habitat encroachment heightens the risk of future shocks, leading to portfolio losses, supply chain disruptions, and broader systemic risks.

For such investors, understanding externalities is a financial imperative: they represent not just headwinds, but portfolio-level risks. Consequently, even modest individual asset returns can be justified by broader portfolio benefits — much like portfolio insurance might protect long-term upside.

The valuation conundrum

The Dasgupta Review frames biodiversity as “our most precious asset” and a “blind spot” in economics. It discusses the need for policymakers, financial markets and supra-national institutions to fully account for the impact of our interactions with the natural world. Yet, the Review also highlights that nature is grossly mispriced by markets, and that treating it as a free resource has driven its depletion⁶.

This article will not dive into the philosophical conundrum of whether we should value nature, but we raise it here because of its longer-term relevance on portfolio construction and investor outcomes. As investors seeking to address the climate and ecological crisis, we need to recognise that valuation is imperfect, often insensitive, and frequently distorted by market failures. To add to this complexity, to build credible Natural Capital strategies, investors must grapple with how to recognise nature’s role in underpinning long-term economic stability and portfolio resilience.

Geographical diversification and jurisdictional risk

We observe that maintaining control over Natural Capital assets is not always easy, particularly in certain jurisdictions where the rule of law and corruption can represent material risks.

Below we provide a simplified mapping of how implementable we see different geographies in a Natural Capital portfolio:

1. Markets where private capital can and needs to provide investible, relevant solutions, working with government where appropriate. This includes the UK, North America, Australia and parts of Europe. In these markets, there is a well-developed set of available strategies, continually evolving best practices in farming and forestry, and a clear path to achieving impact. The landscape includes both specialist boutiques with smaller asset bases and large global managers. However, this remains an emerging area, with relatively few managers having significant assets under management.
2. Markets where government policy will be the dominant driver of change. An example of this is Singapore where policy intervention has been a powerful source of change. Initiatives such as OneMillionTrees, nature-based projects for flood control (Bishan-Ang Mo Kio Park) and government involvement incorporating green spaces in urban planning (70% of the housing stock consisting of public housing), have seen a focus on creating a “garden city” from both an ecological as well as wellbeing standpoint. We have also seen similar initiatives in the UK, such as Biodiversity Net Gain (BNG) requirements. The efficacy of BNG while debatable, is a policy that allows for the measurement and consideration of biodiversity as Natural Capital assets (e.g. farms) are developed over time.
3. Emerging markets such as Central & South America, Africa and parts of Southeast Asia currently include large areas with high-risk primary forests, some of the highest concentration of biodiversity and perhaps the greatest opportunity to use tools such as Payment for Ecosystem Services⁷ for both environmental and social impact. Whilst we are not yet at the point where we feel comfortable including such strategies in our model portfolio, mainly due to concerns over control (i.e. regulatory/legal and jurisdictional risks), we expect this day to come.

Avoiding mistakes

As we move into the growth phase of the Natural Capital product cycle, we have reflected on the recent ESG/clean energy product cycle:

• It is hard to affect significant real-world change from secondary market transactions in listed securities. However, this doesn’t mean that there is nothing that we can do.
• We shouldn’t ignore the importance of engagement in shifting the value-chain of incumbents who present significant balance sheet risk and are also some of the largest contributors to biodiversity loss.
• The highest potential for impact may well be in the private markets, but this will not be automatic.
• Long-termism matters: positive outcomes require patience and a recognition of nuance. Herding behind simplistic narratives such as “ESG = returns” may drive inflows, but without the right time horizon, this is likely to suffer from behavioural fluctuations, undermining both capital allocation to sustainability solutions and investor confidence in the broader discipline.

With these in mind, we now discuss some key facets around portfolio construction, the opportunity set for such investments and how we think different strategies can be combined.

We have also written a thought piece on ESG product cycles examining this topic in greater detail: https://fulcrumasset.com/insights/investment-insights/strategy-cycles-mania-and-the-lessons-for-esg-funds/.

“Vertical Integration” in your portfolio⁸

We recently attended an away day with a manager where we visited several farms, a new forest and a flour mill. The trip helped to clarify some thinking; different strategies within the broad sphere of Natural Capital are going to have different expected returns. For example, we can invest in a regenerative farming project, and it would be unreasonable to expect very high returns from such an investment. We can invest in a growth equity opportunity in an agricultural technology firm and expect high returns (with higher risks). Thus, different stages of the ‘food chain’, are likely to benefit from each other’s increased resilience, a combination of strategies could lead to genuine synergies, if executed well.

Evidence from the International Food Policy Research Institute suggests that integrated strategies can improve accessibility for smallholder farmers by expanding their ability to access the markets⁹. This not only strengthens the weakest links in the chain but also reduces systemic risks that arise when producers face shocks in isolation.

Finally, vertical integration provides a channel for explicit governance influence. Investors can shape sustainability practices across the value chain by embedding environmental and social standards. This can create alignment between producers, processors, and end markets, ensuring that capital not only diversifies risk and enhances resilience but also steers the system toward long-term sustainable outcomes.

Liquidity

Clearly, the extent to which illiquidity risk exists in a Natural Capital portfolio depends on the liquidity requirements of the end investor. Our research has led us to uncover opportunities in listed equity strategies (highly liquid – “Module A”), income-oriented, tradable private market strategies (semi liquid – “Module B”) and long-term impactful private market opportunities (illiquid – “Module C”). Below we show an illustrative portfolio comprising all three Modules, which could easily be tailored according to client requirements.

Importantly, natural assets regenerate over long cycles, so aligning investment horizons with ecological timeframes is essential to avoid mismatches that could undermine both liquidity management and long-term returns.

Source: Fulcrum Asset Management, for illustrative purposes only.

Opportunity set and a sample portfolio

Our portfolios are based on the principle of open architecture, using best-in-class specialists for each underlying mandate. We use our proprietary ‘Four Key Factors’ approach to portfolio construction. The goal of this approach is to put all the opportunities on a level playing field, a Total Portfolio Approach (“TPA”) as it were, enabling genuine comparison across a multitude of factors.

We have been through this process for the Natural Capital strategies we have researched and have come up with a sample portfolio below of our highest conviction ideas. Many of these ideas are already live in several client accounts, but we have also added some new Module C manager ideas to round out the list. As we develop our assumptions for net return volatility (amongst other risks), we attempt to integrate all our due diligence into the subtleties highlighted in this paper, including valuation challenges.

Source: Fulcrum Asset Management, for illustrative purposes only.

Conclusion

We believe that nature’s destruction creates systemic risks, while its preservation opens opportunities for innovation and long-term value creation. This reframes Natural Capital not as a niche impact allocation, but perhaps a systemic risk factor which will be a necessity for investors seeking durable long-term performance.

Building such portfolios requires more than chasing standalone returns. It means balancing risk, returns and impact across the liquidity spectrum, considering geographical diversification and liquidity risks, and aligning horizons with ecological cycles. The opportunity set is broadening from regenerative agriculture in developed markets to emerging opportunities in conservation and ecosystem restoration. Investors now have improved tools to deploy capital with measurable ecological and financial benefits. As the Dasgupta review succinctly puts it – “Nature is our home. Good economics demands we manage it better.”¹⁰