A Whole New Ballgame - Water ETFs

by Stephen J. Hoffmann

Index investing has become a common tool in today’s investment landscape. Proliferation of exchange-traded funds (ETFs), based on indexes, has presented investors with an array of choices. Indexes serve as barometers for an asset class, a particular market or a specific industry, against which financial or economic performance can be measured. They’re a “basket” of stocks selected according to some pre-established rules. Extension of indexes to the water industry provides an attractive vehicle for investing in the compelling fundamentals of the global water industry.

Despite the appeal associated with investing in water through a diversified, tax-efficient product such as an ETF, investors must fully understand the design of the underlying tracking index to make informed decisions. The inherently fragmented and diverse structure of the global water industry, comprised of large international companies as well as specialized smaller cap companies, dictates that the methodology of the underlying index be designed to optimize the potential of this constantly changing industry. All water indexes are not created equally.

The weighting methodology of the index is critical. Some water indexes employ a market-capitalization weighted approach which is intrinsically inefficient because it overweights the overvalued stocks and underweights undervalued stocks. Equal-weighting an index is one way to randomize these errors and fundamental weighting further improves the approach.

The Palisades Water Indexes, from Palisades Water Index Associates LLC (of which the author is a principal), are the only water indexes that don’t employ a market-cap weighted approach. They’re comprised of six water industry sectors fundamentally weighted based on the relative underlying business characteristics of a particular sector: water utilities, treatment, infrastructure, analytical, resource management and multi-business. Within sectors, components are equally weighted at the beginning of each rebalance date.

The frequency by which a water index is rebalanced and reconstituted is another important factor to be considered. The Palisades indexes are rebalanced and reconstituted every three months; other water indexes are adjusted semi-annually or annually. Given the dramatic increase in M&A activity in the water industry, the advent of private equity participation and the overall dynamics of an industry in transition, more frequent rebalancing is preferred, as the opportunity to add new water stocks can be captured in a more timely fashion.

Compilation of the “universe” of water stocks from which the index population is derived is also a distinguishing feature. While most water indexes are generally similar in the component size and liquidity inclusion requirements, selection approaches can vary significantly. For example, several indexes use mechanical screening methods whereas Palisades employs industry-specific knowledge and water business experience to optimize performance. The Palisades indexes currently include two benchmark water indexes, the Palisades Water Index^TM (ZWI) and the Palisades Global Water Index^TM (PIIWI). The associated investable ETFs are licensed for use by PowerShares Capital Management LLC via the PowerShares Water Resources Portfolio (AMEX symbol: PHO) and the PowerShares Global Water Portfolio (AMEX symbol: PIO), respectively.

On the surface, investing in the water industry is relatively straightforward. But as the choices afforded to investors continue to grow through expansion of index investing and related ETFs, it’s becoming increasingly important to drill down to the specific index methodology to determine which products best meet a particular investment profile and objective.

About the Author: Steve Hoffmann, managing director of WaterTech Capital LLC, is a co-founder of Palisades Water Index Associates LLC, founder of TheWaterInvestor.com and managing partner of Water Partners III, a private equity fund focused on water investments. Contact: 469-585-4875 or [email protected]

Water by the Basket

Investment in water can be via individual company stocks or baskets of stocks organized by mutual funds, indexes and ETFs. These last two often include water but focus on infrastructure or utility stocks. An emerging trend is for specific products targeting water more as a pure play:

Water Indexes