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Hot water: How to drop some H{-2}O into your portfolio

rcarrick@globeandmail.com

Looking to jump into an investment in a scarce resource with lots of upside potential? There's a clear case to be made for water.

Oil and gas, metals and fertilizers and food are still going strong, while investors have only recently started to talk about water. And yet, water has much the same imbalance between supply and demand as traditional resources. The investment dealer Goldman Sachs recently described water as "the petroleum for the next century."

Mutual funds and exchange-traded funds focusing on water have been around for a year or so and the early results vary widely. The one certainty is that water stocks haven't yet enjoyed anywhere near the rally that energy, metal and fertilizer stocks have.

The basic argument for investing in water is scarcity, starting with the fact that just 2.5 per cent of the world's water is fresh. Goldman Sachs says consumption of fresh water is doubling every 20 years. The World Water Council says about 1.1 billion people lack access to clean drinking water, and 2.6 billion lack adequate sanitation.

Here in North America, the council says we use about 350 litres of water a day on a per capita basis in residential areas, compared with 200 litres in Europe and 10 to 20 litres in sub-Saharan Africa. Meanwhile, the North American water infrastructure is decaying. The American Water Works Association says much of the water network in the United States will need to be replaced in the next 30 years, and the estimated cost of replacing old pipes comes in between $280-billion (U.S.) and $400-billion.

You may have heard how rising global demand for food has sent the price of fertilizer and agricultural commodities soaring. But water is part of the equation, too. One thousand litres of water are needed to produce a kilogram of wheat, while an equivalent amount of beef requires 13,000 litres.

The scarcity argument in favour of investing in water stocks suggests the potential for gains on par with oil and metals. But while water ETFs have done well lately, it's probably not wise to invest in them with a quick score in mind.

"As time goes on, water will become more and more of a scarce commodity," said Brent Woyat, a portfolio manager at Raymond James in Vancouver who has put clients into an ETF called the PowerShares Water Resources Portfolio. "It's more of a long-term theme, separate from the other commodities."

There are now about five ETFs focusing on indexes of water-related stocks, including the PowerShares fund. Canadian Imperial Bank of Commerce has issued a couple of series of principal-protected notes that invest in water stocks, and there's also a mutual fund in the sector called Criterion Water Infrastructure.

This fund's attributes are its wide availability, its global diversification and its use of currency hedging, which means investors get the returns of the underlying stocks without distortions caused by currency fluctuations. Fees come in at 2.55 per cent for the widely held Class C version, which is high in comparison to the water ETFs that are listed on the Toronto, New York and American stock exchanges.

The PowerShares Water Resources Portfolio is the choice of not only Mr. Woyat, but also Larry Berman, chief investment officer of ETF Capital Management in Toronto. Mr. Berman cites this ETF's liquidity - it generates by far the highest trading volumes among water ETFs - and its mix of big and small corporate names. The management expense ratio is 0.7 per cent, which is somewhat pricey for an ETF but still far lower than mutual funds.

The underlying index for this ETF is the Palisades Water Index, which has top holdings that include URS Corp., an engineering firm with expertise in water infrastructure projects; Tetra Tech, which is a consulting and engineering firm; and Valmont Industries, which makes irrigation equipment.

Stocks like these highlight how investing in water can be different than other commodities, where you can buy directly into companies that explore for and produce energy, metals and fertilizers. "Water falls into the commodity space, but it's also infrastructure," Mr. Berman said.

Companies in the water business can be broken down into the following sectors: utilities, which are regulated suppliers of water to homes and business; treatment, which focuses on producing clean, drinkable water; distribution, which refers to companies that supply pipes, pumps and valves; monitoring, or water analysis; and resource management, which includes consulting and engineering firms that specialize in water projects. There are also diversified industrial conglomerates - General Electric is a prime example - with divisions in the water business.

Several stocks can be found in most of the various water funds and ETFs, including Veolia Environmental, a French conglomerate that gets about one-third of its revenue from water treatment. Veolia was mentioned in a recent Forbes magazine column by Ken Fisher that was headlined: "A stock for eco-nuts; If you are a greenie, buy Veolia Environment. If you aren't, buy it anyway." Other water stalwarts include Itron Inc., which supplies water meters, and Danaher, a diversified U.S. industrial firm with expertise in water purification.

Suggestion: Forget about picking individual stocks and instead find an ETF or mutual fund to give you broad exposure to water. The usual ETF selection criteria apply: fees (as low as possible), liquidity (you want an actively traded fund) and the makeup of the underlying index (broad diversification is what you want).

Mr. Woyat has about 5 per cent of client portfolios in the water sector, but suggests caution for investors who want to jump in now. "If I were to enter the market, I'd probably wait for a bit of a pullback. The way [water ETFs] are trading, they could be riding on the coattails of other commodities."

If you do put water ETFs in your portfolio, recognize that you're making a speculative investment that adds risk to your portfolio. "You're getting into these to basically chase a story," said Richard Kang, an investing industry consultant who blogs at The Beta Brief (thebetabrief.com). "Don't get into it as a diversifier."

Tapping into water

Investors can now buy exposure to companies involved in the water sector through exchange-traded funds listed on U.S. and Canadian indexes, as well as a mutual fund. An overview of what's available:

EXCHANGE-TRADED FUNDS

Stock symbolMER (%)Ytd price chg (%)1-yr price chg(%)
PowerShares Water Resources PortfolioPHO-Amex0.70%2.50%8.70%
PowerShares Global Water PortfolioPIO-Amex0.75-9-8.9
Claymore S&P Global Water ETFCWW-TSX0.67-5.8-6.7
Claymore S&P Global Water Index ETFCGW-Amex0.65-5.4-1.4
First Trust ISE Water Index FundFIW-NYSE0.63.310.9

MUTUAL FUND

Stock symbolMER (%)Ytd price chg (%)1-yr price chg(%)
Criterion Water Infrastructure (Class D)n/a2.55-7n/a

Notes: Prices are to June 12; U.S.-listed ETF returns are in U.S. dollars

KATHRYN TAM/THE GLOBE AND MAIL

SOURCES: COMPANY WEBSITES; AMEX; GLOBEINVESTOR.COM

© 2007 The Globe and Mail. All rights reserved.

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