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The Most Popular Way to Invest in U.S. Water Stocks

Water as an investment attracts two types of investors who are distinctly different. The first type are income investors, perhaps retirees, who see the safety and dependability of a steady growing dividend as a protection against inflation. Many utilities along with water utilities provide this safety. The second type of investor is someone who is looking for growth opportunities and who believes that water is a scarce commodity. This investor wants to invest in any  disruptive technology that could potentially solve the world’s water shortage problem. One obvious solution to the water scarcity problem is to turn the salt water all around us into fresh water. This process is called desalination and could very easily solve our water problems. In past articles, we looked at the top-20 desalination companies globally, and found none of them were viable publicly traded pure plays on desalination except perhaps Hyflux

So if you wanted to invest in “water stocks” because you see them as a growth opportunity, one way to do so with the least amount of risk would be to diversify and buy a collection of all water stocks. The easiest way to do this is through buying a water ETF. ETFs or exchange traded funds are just like a passive mutual fund but without all those fees and rules. ETFs are a cost effective way for most retail investors to diversify since ETFs typically charge lower fees than mutual funds, they trade like stocks, and they have to track a particular index which serves as a performance benchmark.  Let’s take a look at the most popular water ETF on the market, the Powershares Water Resources Portfolio (NYSEARCA:PHO).

PowerShares_Water_Resources_Logo

This ETF tracks the NASDAQ OMX US Water Index and has attracted about $850 million from investors which is more than double the assets under management of the nearest competing ETF, the Claymore S&P Global Water Index (NYSEARCA:CGW). PHO’s ETF methodology is to invest at least 90% of its total assets in common stocks and ADRs of companies that comprise the underlying index. So what does the underlying index look like? The NASDAQ OMX US Water Index makes the following statement regarding the methodology used to pick the 28 “water stocks” which currently comprise this index:

The NASDAQ OMX US Water Index is designed to track the performance of companies creating products that conserve and purify water for homes, businesses and industries that are listed on an U.S. exchange. The index is weighted to enhance the underlying liquidity and increase the tradability of the index components.

While that’s the goal of the index, PHO’s only requirement is to invest at least 90% of their assets in any number of companies contained within the index. If we were to take the top-10 companies in PHO and then compare them to the top-10 companies in the NASDAQ OMX US Water Index, we would see the following differences:

PHO_VS_NASDAQ_WATER_INDEX

Source: Invesco and NASDAQ OMX Latest Fact Sheets as of 4/20/2015

It is very surprising to see only 6 companies in common between the top-10 water companies in the ETF and underlying index. So with such a difference in constituents, we would expect to see a difference in performance between the NASDAQ OMX US Water Index and the Powershares Water Resources Portfolio which can be seen below:

PHO_Historical_Performance

Source: Invesco Powershares Water Resources Portfolio (PHO) Fact Sheet

The problem here is that PHO has returned less than the underlying index over the past 9 years. The fund managers could be tracking this index much closer to at least provide the index return minus the .61% expense ratio. While benchmark performance is one way to evaluate the success of an ETF, we’re more interested in understanding the underlying methodology. When we take a look at the industry and sector breakdowns for the 28 companies in the Powershares Water Resources Portfolio, we see only 17.5% of the portfolio is allocated to water utilities and a staggering 66% is allocated to industrials:

POH_Industry_Sector_Breakdown

Source: Invesco Powershares Water Resources Portfolio (PHO) Fact Sheet

In an article from Bloomberg last year titled “Water ETFs are Smarter Than They Look“, the below case was made for investing in “water industrials” as opposed to water utilities:

Water utilities are subject to regulation, and as water gets scarcer they could be slapped with price controls or usage limits. They’re also sensitive to rising interest rates because utilities are favored for their high income when rates are low.

Investing in the scarcity of water, it turns out, means buying industrial companies that conserve, purify and treat water, as well as those that make equipment and deliver new technologies to the water industry.

It seems like PHO is taking this exact same approach in their choice of stocks to include in their portfolio and which weightings to use. In a future article, will take a closer look at some of the top companies held in the Powershares Water Resources Portfolio (NYSEARCA:PHO), the most popular way to invest in U.S. water stocks today.

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