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.