Water ETFs Are Smarter Than They Look

Photographer: Ken James/Bloomberg

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Photographer: Ken James/Bloomberg

It's easy to ridicule exchange-traded funds that invest in water. They seem an obvious example of products becoming too specialized and gimmicky. Are earth, wind and fire ETFs next?

Then there's the fact that water ETFs don't track the price of water, and don't focus on investing in water utility companies.

All that said, the reasons for wanting to invest in water make sense. Next to air, it is the world's most precious resource in supporting life. And over the last century, water usage worldwide has been increasing at more than twice the rate of population growth, according to UN-Water.org. Water scarcity is cited as a likely reason for future geopolitical conflicts.

The thing about water is that, unlike with oil or natural gas, investors can't bet on its price using futures contracts. No speculator can corner the market in water. Also, 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.

The strategy has performed well recently. Water ETFs returned more than 4.8 percent in August, besting the S&P 500's 4.3 percent, and have attracted just shy of $2 billion in assets since their inception in the mid-2000s, a lot for a niche category. Their long-term record isn't great: All have underperformed the S&P 500 for 1-, 3- and 5-year periods. That said, in terms of investing logic, water may be the ultimate long-term play -- until an air ETF crops up.

Here's a look at what the three largest water ETFs offer investors. All have a majority of their holdings in industrials, with a smaller chunk in utilities, and charge over 0.60 percent in fees. That's pricey for an ETF but common in areas where Vanguard Group or Charles Schwab Corp. don't compete.

PowerShares Water Resources Portfolio (PHO)

The largest of the lot is PHO, at $980 million in assets. It holds U.S. companies making products designed to conserve and purify water for homes, business and industries. The ETF has 66 percent in industrial stocks, 17 percent in utilities and a smattering in health care, technology and materials companies. Its portfolio is weighted by the market capitalization of its stocks, and the top 10 holdings make up 60 percent of the portfolio. The top three stocks are Roper Industries Inc. (ROP), Waters Corp. (WAT), and Flowserve Corp. (FLS). PHO charges 0.62 percent in annual fees.

First Trust ISE Water Index Fund (FIW)

FIW tracks the 36 largest U.S. companies in the potable and wastewater industry. While it has a similar sector allocation to PHO, the stocks are weighted differently. The top stock gets at most a 4 percent weighting, a method known as "modified-equal weighted." FIW will likely have higher highs and lower lows because of its exposure to more volatile, smaller-cap stocks. It has $200 million in assets and charges 0.61 percent.

Guggenheim S&P Global Water ETF (CGW)

CGW is a global play and has 40 percent in water utility companies, the most among water ETFs. It has a 55 percent weighting in western Europe, 30 percent in North America, and 12 percent in Asia. CGW is the best year-to-date performer of the bunch, with a return of 5.4 percent compared with a loss of 0.08 percent for PHO and a gain of 0.33 percent for FIW. It has $367 million in assets and charges 0.70 percent.

On the mutual fund side, the biggest water fund is the Calvert Global Water Fund (CFWAX), which has $604 million in assets. Its portfolio allocations are similar to the water ETFs', but it has much higher fees. CFWAX has an expense ratio of 1.85 percent, plus a 4.75 percent front-end load.

When considering thematic or sub-sector ETFs, check for overlap with existing popular ETFs. You don’t want to buy into something you already own. Water ETFs pass that test -- their holdings have little representation in major broad market and sector indices. The most overlap is with industrial-sector ETFs, which hold a handful of these stocks.

More stories from Eric Balchunas:

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Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here, and weekly ETF podcasts can be found here.

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