THE ETF EXPERT: Assets Pouring into Water ETFs

Investing in water resources is a study in contradictions. In some ways, the proposition seems irresistible: who would not want to own companies that produce or distribute an item that is essential for human life, exists in limited quantities, has no known substitutes, and is projected to become dangerously scarce in the years ahead? On the other hand, why put money into companies selling something most people regard as an inalienable birthright, which literally falls from the sky in massive quantities, and that can usually be found just about anywhere, free for the taking?

The potential for profit is undeniable: global spending on water resources was about $463 billion in 2007, according to consultants Global Water Intelligence, for products ranging from water utility service to irrigation equipment, household water appliances, bottled water, and industrial water.

Finding companies to extract profit from that market takes more effort: most U.S. water utilities are municipally owned, with investor-owned companies holding just a 16% share of the market. There are few major corporations focused on the water industry: the largest U.S. water utility is American Water Works (AWK), a New Jersey-based company that owns or manages regulated water utilities in 32 states and has a market capitalization of just $3.5 billion. In 2008 it posted a net loss of $560 million on revenue of $2.4 billion. While several large corporations such as General Electric (GE) or Siemens (SI) have significant water-related businesses, they are relatively small parts of the overall companies.

Standard & Poor's Equity Analyst Stewart Scharf has a neutral outlook for the water utilities sub-industry over the next 12 months, as weak economic conditions and the housing market meltdown stunts growth in new customers. The budget crunch that many state and local governments are experiencing may, however, lead some to sell their water utilities to private investors, he says.

Sensing a market niche, since 2005 distributors of exchange traded funds launched four ETFs focused on water-related stocks; those ETFs now hold about $1.8 billion in combined assets. Of the four, two are primarily (but not entirely), focused on the U.S. market, while the others are explicitly global in scope. These funds all took a beating during the market implosion of late 2008 and early 2009, but rebounded strongly since the overall market hit its low in March.

Predictably, the first fund off the mark has garnered the lion's share of the market. PowerShares' Water Resources Portfolio (PHO), which began trading in December, 2005, has grown to $1.35 billion in assets, more than six times its largest competitor. It tracks the Palisades Water Index, an equal-dollar weighted index of 35 companies engaged in providing drinking water and wastewater treatment. Most of its holdings are U.S. domestic equities, though it does hold shares of Veolia Environment (VE), the Paris-based environmental services giant that is the largest water company in the world, as well as Companhia de Saneamento Basico do Estado de Sao Paulo (SBS), the water utility for Sao Paulo, Brazil.

Most of the fund is invested in industrial companies, such as Massachusetts-based Watts Water Technology (WTS), which makes water valves. Water utilities make up less than 12% of the fund's holdings.

A similar fund is the First Trust ISE Water Index fund (FIW), with $39 million in assets; it started trading in May, 2007. The ISE Water Index is a capitalization-weighted index comprised of companies that derive a "substantial" part of their revenue from water service and wastewater treatment. Like the Water Resources Portfolio, it owns 36 stocks including Veolia and Sao Paulo Sanitation--its two largest holdings--as well as Illinois-based Nalco Holding (NLC), the largest U.S. industrial wastewater treatment company.

Due to its index composition rules, which select the largest companies from the available universe, the First Trust fund tends to own larger companies than the Water Resources Portfolio, which only has 10% of its assets in large-cap stocks.

Two other funds, the PowerShares Global Water Portfolio (PIO) and the Claymore S&P Global Water Index (CGW), allocate less than 40% of their resources to U.S. companies. The PowerShares fund, which has $275 million in assets and tracks the Palisades Global Water Index, has about 30 holdings with slightly more than half the fund in industrials and about 30% in utilities. Its largest holding is Helsinki-based Kemira Oyj (OKAC London), which makes industrial water treatment chemicals. Claymore's water fund, with $200 million in assets, has about 40% of the fund in water utilities. Veolia Environment is the largest holding and about 10% of its assets. While the Claymore fund has more holdings than the others with about 50 different names, it is more concentrated than the other funds, with the five largest holdings accounting for about 35% of the fund.

* From W. H. Auden's poem, "First Things First."

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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