Water ETFs: What They Are and How They Work

What Are Water ETFs?

Water exchange-traded funds (ETFs) are professionally managed and allow investors to put money in the water industry without having to select and assess companies in the sector one by one. These ETFs hold stocks from water companies, including utilities, infrastructure, and treatment firms.

The water sector is all-important for economic growth, environmental sustainability, and the fundamental needs of life. Around 2 billion people worldwide lack access to clean and safe water, highlighting this sector's critical need for development. Water infrastructure forms a cornerstone of sustainable development. Drinking water, agriculture, and food production all rely on this industry.

Supplying drinking and other forms of water, wastewater treatment, and related services is also essential to modern life and the world's economy. In the U.S., firms in the industry and public water authorities grapple with public health hazards, water utilities face budget constraints, rising consumer costs, climate change, droughts, massive drainage in underground water supplies from years of misuse, and chronic underinvestment.

By investing in these ETFs, investors can put money into firms responding to the rapidly rising global demand for water. Water ETFs offer the chance to invest in an essential resource while supporting businesses striving for sustainable water management. Investing in these funds is a strategic move for those who see water scarcity as a significant global issue, making them a crucial part of a diversified portfolio.

Few industries can claim as much importance as this one.

How Water ETFs Work

Water is a vital resource, and understanding the water industry, its potential risks, and opportunities is crucial for investors, communities, and nations facing water scarcity issues worldwide. The sector faces challenges such as contamination but also works to find solutions to solve one of the world's most significant problems.

Like other ETFs, these funds are pools of capital that hold stocks or derivatives tracking companies in the water industry. The ETFs trade their shares on the major stock exchanges like individual stocks. Here are three significant parts of how ETFs work:

• Sponsors: These firms create, market, and manage ETFs. However, sponsors, also called issuers or ETF managers, don't create ETF shares.
• Market-makers: Companies that work with ETF sponsors and the stock exchange to ensure there's always a supply of shares in the ETF so you can easily enter or exit your water ETF position.
• Authorized participants: All ETFs involve authorized participants who create and redeem shares for the ETF. This role is needed so that the shares trade as close as possible to the value of the water ETF's underlying assets. Traditionally, major financial institutions like Morgan Stanley and JPMorgan Chase & Co. have played this part, creating ETF shares by buying the underlying assets (water stocks and so on) and exchanging them for shares in the fund. Going the other way, authorized participants buy ETF shares from investors and redeem them for the underlying assets held by the ETF.

The price of ETF shares is determined by the net asset value of the stocks and other holdings in the water sector and is divided by the number of shares outstanding. When reviewing these ETFs, you'll want to assess their expense ratios, assets under management, liquidity, and underlying holdings, among other matters.

First entering the market in 2005, water ETFs have shown resilience given the constant need for water in life and almost all industrial sectors. In addition, specific trends in water ETFs usually mirror global water issues. An increase in investments may indicate a growing awareness of water scarcity and a commitment to sustainable water management. However, their returns, like all investments, are subject to market fluctuations. 

Benefits of Investing in Water ETFs

Investing in these types of ETFs has several advantages. Water ETFs typically hold shares in companies focused on water purification and efficient usage. For instance, the Global X Clean Water ETF (AQWA) puts money into companies producing more clean water through industrial water treatment, storage, and other methods. Investing in this area also allows you to support and benefit from organizations actively addressing water scarcity and quality issues.

Water ETFs typically hold shares in companies like Danaher (DHR), Ecolab (ECL), and Pentair (PNR), which are involved in producing and putting in place water-related technologies and services that help mitigate the effects of the global water crisis. Here are some more potential benefits of investing in water ETFs:

• Growing demand: Given the increasing global population and urbanization, the demand for clean and accessible water has been rising rapidly. This should mean growth for the sector.
• Diversification: These ETFs typically invest in assorted companies involved in different aspects of the water industry, including treatment, infrastructure, and technology. Thus, you get broad exposure to the entire industry rather than depending on the performance of specific companies. In addition, these ETFs typically hold shares in companies from subsectors like utilities, infrastructure, and technology.
• Global exposure: Water ETFs often hold shares from companies working globally, providing exposure to international markets and reducing country-specific risk.
• Inflation hedge: Utilities, a major component held by water ETFs, are typically seen as a good hedge against inflation because they can pass on increased costs to consumers and there is demand for the essentials they provide even when the market tumbles. The water sector's performance also has some negative correlation with other assets.
  
• Potential for stable returns: Water is a basic human necessity; thus, the industry tends to be less volatile than other sectors. This could offer more stable returns over the long term.
• Sustainability: Investors can contribute to sustainable development goals by investing in water ETFs. Many water-related companies are working on solutions to address water scarcity and pollution. As global water scarcity intensifies, there's also a growing focus on making water use more efficient. Buying shares in these ETFs indirectly supports companies at the forefront of these efforts, potentially driving progress toward more sustainable practices in the industry.
• Tech opportunities: The water sector is ripe for finding inventive solutions in areas like desalination, wastewater treatment, and smart metering. Companies leading in these areas can offer attractive investment opportunities since their products will be in demand.
  

Despite these potential benefits, the suitability of water ETFs for your portfolio depends on your asset allocation, financial goals, and risk tolerance.

Top Water ETFs

The top three water ETFs regarding assets under management traded in the U.S. are PHO, FIW, and CGW.

Invesco Water Resources ETF (PHO): With an expense ratio of 0.60%, this ETF tracks the investment results of the Nasdaq OMX U.S. Water Index. As of January 2024, it had assets under management (AUM) of about $1.89 billion. The PHO ETF primarily invests in securities of companies in the water industry, focusing on sustainability and resource management.

First Trust Water ETF (FIW): This ETF targets companies engaged in the potable and wastewater industries. FIW ETF has an expense ratio of 0.53% and an AUM of about $1.48 billion. The ETF tracks the price and yield of the ISE Clean Edge Water Index.

Invesco S&P Global Water Index ETF (CGW): This ETF tracks the S&P Global Water Index, offering exposure to 50 of the largest corporations globally involved in water-related businesses. Its expense ratio is 0.57%, with an AUM of about $933 million. The fund focuses on companies providing potable water, wastewater services, and other equipment and materials used for treating water.

As always, before investing in these or any ETFs, do careful due diligence and double-check recently updated information about these funds.

Risks and Challenges of Investing in Water ETFs

Despite the potential for long-term growth because of the dangers to the global water supply, there are significant risks that investors need to consider. Let's go through some of them:

• Concentration risk: Water ETFs tend to be focused on specific sectors, countries, or groups of companies. This concentration can expose investors to more risk if that area faces a downturn or upheaval.
• Greenwashing: This is when companies overstate their environmental credentials. While the value of specific companies usually don't plunge because of reports of them emphasizing environmental, social, and governance (ESG) credentials they haven't earned, reports of problems caused by companies for the environment and water supply certainly can.
• Liquidity concerns: Some water ETFs are not as heavily traded as others, which could lead to liquidity issues and make it more difficult for you to enter or exit your position in them.
• Market volatility: Water ETFs are subject to fluctuations caused by natural disasters or political instability.
• Regulatory changes: Changes in environmental policies and regulations can affect companies in the water sector. Changes in regulations could lead to increased costs, influencing their profitability.
• Vague disclosure details: A significant challenge is the inconsistent and frequently missing disclosure of corporate water practices, making it difficult for investors to assess the actual value of their investments.
• Water scarcity and quality problems: Dwindling water sources, pollution, and climate change pose significant challenges to the water industry. These issues can increase operating costs and decrease the returns of water ETFs.
  

Lastly, it's worth noting that these are thematic ETFs and, therefore, may not be suitable for all investors. Investing in water is driven by ensuring access to clean and safe water, which is a pressing ESG challenge. However, this thematic approach might not align with every investor's strategy or risk tolerance.

How to Invest in Water ETFs

Investing in water ETFs is relatively straightforward and can be done through your brokerage account. If you don't have one, you need to open an account, deposit funds, and buy shares of the desired water ETFs. Each ETF has a unique ticker symbol for trading on the stock exchange.

To choose the right water ETF, review the fund's expense ratio, its investment strategy, and the specific segment of the water industry it targets. Keep an eye on your portfolio and seek advice from a financial advisor if needed to ensure it remains aligned with your risk tolerance and investment goals. 

The Bottom Line

Water ETFs offer the opportunity to tap into the critical water sector, providing diversification and the potential for stable, long-term returns. However, these ETFs carry specific market risks, including the potential for costly regulatory changes and operational issues within water companies. Despite these risks, the long-term benefits of investing in water ETFs, especially for addressing ESG challenges, make them appealing to many investors.