Friday, November 24, 2006

Will This Water ETF Keep Investor Profits Flowing?

The New Yorker recently published an eye-opening article on the water shortage in the developing world and the possibility of global catastrophe. News reports of pollution in China's Yellow River and competition for water resources in India lend credence to the concern. Could water be the next oil, a commodity with huge price appreciation potential? The PowerShares Water Resources ETF (PHO) is one way to take advantage of this theme through a diversified group of stocks.

The PowerShares site explains that PHO is based on the Palisades Water Index, which tracks companies that focus on the provision of potable water, water treatment, and technology devoted to water consumption. Over 52% of the portfolio consists of small-cap issues, while large cap accounts for about 11% and mid-cap about 37%. Industrials and utilities represent the largest sectors at nearly 60% and over 25% respectively. Over 36% of the portfolio is concentrated in the top ten holdings.

So how does the ETF behave? As the chart above indicates, PHO has been strongly correlated with the small cap stocks since its inception. It remains below its May peak, thus behaving more like a small cap growth stock than a value issue. The correlation between daily price changes in PHO and IWM is .81, meaning that over 64% of the variance in PHO price from day to day is accounted for by movement within the broad small-cap universe. The average price change from day to day in PHO is only slightly greater than for IWM: .96% vs. .87%. Interestingly, average volume for PHO has not grown over its relatively short lifetime. It peaked during its market peak in April, 2006 and is down to early 2006 levels at present.

My earlier report on a promising sector ETF, the PowerShares WilderHill Clean Energy Fund (PBW), found that this fund has been growing its volume and is considerably more volatile than the Russell index. This points to a difference between the two funds: clean energy may be more on the radar of U.S. investors than water resources and hence generating greater speculative interest. Unfortunately, it is far easier to see Congress and the President aggressively moving on domestic alternative energy funding than water initiatives in developing countries.

Nonetheless, there appears to be growing interest in ETFs with a conscience since the Democratic victory in Congress, so I'm keeping my eye on PHO. It has underperformed the recent market rally and its component stocks sport a generous 22 multiple to current earnings. Given the strong correlation with the small cap indices, my leaning is to wait for the next market pullback and assess the action in PHO from there. Although initial volume has been impressive for a relatively new ETF, I will want to see growing investor participation in the fund as a sign that the water-as-natural-resource theme is taking hold.


yinTrader said...

Hi Brett

Investment in water is timely and we in Singapore have our own brand :Newater

Recycled waste water — known as gray water (1970) — is nothing new. As water becomes an ever more precious commodity, many jurisdictions are taking a second look at the old treat-it-and-dump-it model. New waste-water treatment plants are coming online all the time and are purifying water enough that it can be reused as part of manufacturing processes, crop irrigation, and the watering of public parks and gardens. What's
new about newater are the extra purification steps that make the recycled water perfectly safe to drink. The term newater has so far been a strictly Singaporean phenomenon, but with many places looking to deliver recycled water as tap water within the next ten years or so, newater may one day become an accepted part of the linguistic water supply.

We may survive without oil but not water!

Brett Steenbarger, Ph.D. said...

Thanks so much, Yin; I wasn't aware of the Newater phenomenon in Singapore. It makes perfect sense and may be a worthwhile investment theme in your part of the world.


Cavemanus said...

Dr. Brett,

As usual, a good post. Keep up the good work.

I have owned PHO almost since inception and it has performed very well. Compared to other water ETF's, I find PHO a little more diversified than CGW and PIO in holdings, but a little less geographically. That said, many of the US based companies that are held in PHO have strong international sales.

I agree that some of the individual stocks held in PHO have made a real nice run over the past year or so. Some of them, however, have corrected recently. I am watching to add to my position in PHO under $20, should it drop to that level.

I have written a post on my blog about water which also compares the four water ETF's if you want to check it out at:

Long PHO in my Roth IRA