PowerShares Water ETF Lacks Focus

It may seem as though the global economy runs on oil, but another commodity may be just as essential: water. Water is needed to sustain all life on Earth, of course—but it also plays an overlooked role as an essential ingredient for countless industries.

To make a ton of steel, for example, 62,000 gallons of water are needed. Building a car takes about 39,000 gallons; manufacturing a semiconductor uses about 3,000 gallons; and producing one barrel of crude oil uses about 1,800 gallons. And considering the enormous amount of water used for agriculture (70% of the world’s supply), the fact that 90% of the world’s diseases are water-related, and the increasing scarcity of clean water in the face of rising populations—it makes sense to look to the water industry for investment opportunities.

PowerShares Dynamic Water Resources ETF (PHO) is one of the few funds to do just that. PHO tracks the Palisades Water Index, which includes shares of water utilities, wastewater treatment companies, and other firms that offer water-related services and products. That leaves the fund open to stocks of a surprisingly broad array of companies, from small start-ups that manufacture innovative water filtration devices to such giants as General Electric (GE), which brings in a very small percentage of its revenues from working on water projects within its infrastructure division.

That said, Morningstar recently classified more than 80% of PHO’s holdings as mid-cap or smaller, reflecting a heavy bias toward smaller firms that make the bulk of their profits from water-related business. Altogether, the fund’s recent 35 holdings had an average market cap of about $3.3 billion. And though the fund is geared for a global take on the water industry, only about 9% of its assets were recently invested in foreign stocks.

PowerShares launched PHO in December 2005 as the first fund to offer a pure play on water. Investors quickly jumped on board, ballooning the fund’s assets to more than $1.3 billion in about a year. Recently, the fund’s total assets amounted to more than $2.19 billion, far more than most of PowerShares’ single-sector funds can boast. The popularity of the fund could be a sign that its focus on an often-neglected commodity makes sense. But not everyone thinks so. Morningstar analyst Haywood Kelly calls the index PHO tracks “pure gimmickry” and argues that lumping such a diverse group of companies together “results in one hodgepodge of a portfolio.”

Kelly may be right about much of PHO’s appeal being based on the easily marketable idea that companies should be able to profit by trafficking in the most basic of essential commodities. However, PHO doesn’t behave anything like a typical commodities fund. Commodities funds ordinarily move in concert with the value of the commodity they track: When gold prices rise, a gold fund will perform well. But there currently is no market for trading water and no other way to accurately gauge the current value of the resource.

So rather than looking at this fund as a direct stake in water, it might make more sense to think of PHO as an infrastructure fund with a water focus. PHO invests in stocks from several different sectors, but the majority of its holdings are in some way involved in the construction, maintenance and operation of water-related infrastructure. Recent top holding URS (URS), for example, is a major U.S. government contractor that engineers and constructs power plants, military facilities and a wide range of other infrastructure, including wastewater treatment plants. Like many of PHO’s holdings, it’s a bit of a stretch to call URS a water stock, though a small portion of its profits may be tied loosely to demand for the resource.

Most of the investors and analysts who are enthusiastic about investing in PHO’s stock portfolio are looking well into the future, taking into account the prospect of major environmental crises over the coming decades and the explosive growth in the population and economies of such countries as China and India. While these factors may eventually cause water-related stocks to rally, in the near term there are some signs that the water industry could be in for a dry spell.

About 40% of water consumption in the United States is from industrial applications, and if economic growth continues to drag, PHO’s holdings may follow suit. A February survey of water industry professionals, conducted by market research firm ChangeWave, found a 14% decline from a year earlier in the number of respondents who felt spending on water projects would increase over the following 12 months. Still, 64% of respondents said they thought spending would increase, leaving significant room for optimism.

To keep up the pace of the fund’s first few years, PHO’s holdings will need to perform strongly. After gaining more than 22% in 2006 and almost 17% in 2007, the fund was about even for 2008 (as of May 22). The fund ranks 16th on the PowerShares Momentum Tracker Table this week for the third consecutive week. That’s the highest PHO has reached since early January. If the global economy remains strong enough to support major infrastructure projects and if water shortages in various regions of the world become more severe, PHO may receive the boost it needs to shoot further up the table. But this fund’s tight focus on an unusual mix of stocks—many of which are quite small—could make for unpredictable and volatile performance regardless of the demand for water.

Comments

[Eric K:]

I'm confused. This article makes one believe that investors in this fund actually thought they were buying a commodity. Anyone that has followed this fund knows that it is a play on infrastructure for water. How about giving small investors a little more credit. This is a long-term buy and hold.

2008 May 30 07:40 AM

[Kris Tuttle:]

I think PHO is pretty much what it's supposed to be. It's a diverse bunch of stocks with some leverage to water infrastructure. There will certainly be better examples of these with more elaborate research behind them. For now though PHO is a decent proxy for those without the expertise to hold individual water plays. [R2 Capital owns a small position in PHO as we continue to work in the space to find more leveraged ways to play water.]

2008 May 30 09:09 AM

[Panskeptic:]

The article is a lot less useful than it might be, as CGW and PIO are not even mentioned. Do they have the same problems? Is one or both of them preferable? It's not at all clear.

2008 May 30 09:58 AM

[Vinsanity:]

Agreed. Give us a solution to the problem.

2008 May 30 11:45 AM

[Everyday Fi...:]

Infrastructure funds and ETFs themselves not billed as "water plays" are great in this environment of burgeoning global growth - from airports to highways for sale to the global buildout occurring. Here's a post on several such plays with some fat dividends to boot:

everydayfinance.blogsp...

2008 May 30 09:51 PM

[Uncle Larry:]

It is interesting that none of the stocks are involved in hydroelectric power, like Great Lakes Hydro.

2008 May 31 09:00 AM

[BAWE:]

How about a similar article on PIO

2008 Jun 02 09:31 AM