Investing in Water? A Deeper Look into the PowerShares Water Resources ETF (PHO)

The PowerShares Water Resources Portfolio (PHO) is up 17% so far in 2006, blasting past both broader market indexes and related sector indexes such as utilities, natural resources, and clean energy. In fact, the S&P 1500 Water Utilities Index rose 46% in 2005.

Why the sudden interest in water? Let's explore news and statistics on the sector first and then discuss why PHO is the best way to play it.

The surfacing concerns about water aren’t so much about the supply and demand for water as a resource. Water covers 70% of the earth and gets continuously recycled and reused. The issue is taking the abundance of water on the earth and making it usable for consumption. While 70% of the earth may be covered in water, 97% of that water is filled with salt and other pollutants. The water must be purified prior to distribution and use. Salty water is of little to no value in industrial consumption, or to the agriculture industry which consumes large quantities of purified water through irrigation systems. The bottled water industry itself provides generous revenue streams to companies that research water treatment methods and more efficient means of purification. Of the remaining 3% of available, non-salted water, a very limited amount is readily available. Aha! A supply shortage- this is when you should start thinking profit and exploring what the best investment product may be.

How can an investor play the water sector? This is something I’ve been exploring for a while. Prior to December 6th, the inception date for the PowerShares Water Resources Portfolio, I was still researching mutual fund managers with interesting utility plays. This was no silly idea. Judith Saryan of Eaton Vance (a very global thinker) has put together a nice little fund (EVTMX) which would have returned you 30% on your capital in 2005 in addition to an increasing dividend. However, this is hardly just a water play. It strays from utilities to give energy exposure and even communication service providers.

The PowerShares Portfolio really hits the sweet spots of the water industry. They seek companies involved in every angle of water purification. This can be a very "green" concept in that pollution is a major detriment to clean water. PHO invests in environment-friendly companies such as the California Water Service Group (CWT) that both purify water and provide facilities and technology for water testing and inspection. They also look for companies that treat water for use in industrial processes. These companies do not operate exclusively in the West. China and the Middle East have a huge demand for pure water, both for industrial purposes and basic consumption. The ability to transport water greatly affects countries such as Israel, Jordan, and Lebanon where arid conditions make agriculture quite difficult. Finally, PHO recognizes the growing bottled water industry. Remember the days when people turned on their sink for a glass of water? Even I don’t do that anymore.

The PowerShares Portfolio is based on the Palisades Water Index, a quarterly rebalanced portfolio of 25 stocks created in 2003 by Elias Azrak of Hydrogen Ventures, LLC. The PowerShares Portfolio may vary its weighting on different stocks in the sector and maintains a 20% flexibility in straying from the sector when appropriate.

Please note that while PHO is passive as compared to a mutual fund, the ETF tends to re-weight and switch holdings regularly with its rigorous rebalancing schedule. The intellidex system used by PowerShares tends to favor smaller capitalized stocks with aggressive growth rates rather than large-cap stocks. This has been a great strategy thus far for PowerShares but adds a degree of volatility for investors.

There is a more passive ETF that tracks water stocks in addition to utilities offered through iShares (IDU). This index is much less popular than the PowerShare. In fact, the average trading volume on PHO has recently crossed 500,000 shares/day, impressive for an ETF launched just three months ago. PowerShares also tends to be an expensive ETF (PHO runs you 60 basis points). While there is a cost to rebalancing and obtaining securities for an index, I believe the higher expenses of PowerShares are well worth it. It’s still cheap relative to most mutual funds.

Economists estimate $500 billion being spent in the next 25 years on research and infrastructure related to clean water initiatives. Another $100 billion is estimated for researching health concerns regarding pollutants which affect water and other natural resources. I’d think about that and add some weight to PHO in the portfolio.