Paul Justice, contributor to Morningstar ETFInvestor, weighs the pluses and minuses of an ETF devoted to the growth and development of water resources.

Few thematic investments have been as popular as the “water sector.” Four ETFs are available in this niche, and they have accumulated nearly $2 billion in aggregate assets.

As the world population increases and existing water supplies are strained, the demand for clean water has also increased. Global water consumption has increased nearly twice as fast as population growth in recent years, and some projections expect the water industry to be a trillion-dollar market as early as 2020.

Such growth seems to make an investment in water-related companies a compelling idea, but making such an investment idea actionable has proved difficult. Many of the profitable improvements expected to be made in the water industry are coming from two firms, neither of which are classified as water companies and, hence, not included in this index.

The largest fund in the group, PowerShares Water Resources (NYSEArca: PHO), tracks the Palisades Water Index, which represents the stock-market performance of companies in the global water industry, such as water utilities, water-treatment firms, and companies that provide related products and services.

The index typically has between 30 and 40 constituents. The portfolio is equally weighted, uses a sampling approach, and is rebalanced quarterly.

This fund does the best job of capturing an investable water theme available on the ETF market, [but] there are too few companies that focus only on water-related equipment to produce a high-quality index.

What kind of portfolio do you get? For the most part, the fund equal weights its 30 or so holdings—rebalancing quarterly—so no stock ever grows to become dominant. In the fourth quarter of 2009, the weightings ranged between 5.3% for top-holding Tetra Tech (Nasdaq: TTEK) to 1% for the bottom holding, Consolidated Water Holding (Nasdaq: CWCO).

The average market capitalization of the stocks in the portfolio is $1.9 billion, putting the fund in mid-cap territory. So, generally speaking, when smaller stocks do well—or when industrials and utilities stocks are hot—this fund’s returns will look attractive.

Of the four “water” ETFs available, this fund is by far the largest and most liquid, and its fee is the lowest. (PHO’s expense ratio of 0.6% is a bit high relative to other ETFs, but it is consistent with other thematically focused funds.) Given its extremely narrow focus, this thematic ETF should be treated as a satellite holding. We wouldn’t recommend letting this fund occupy more than 5% of investable assets, and we probably wouldn’t buy it at all.

In our opinion, the best alternative would be Industrial Select Sector (NYSEArca: XLI), as you’re really just getting an industrial fund with a small utilities investment when you buy PHO. For just 0.21% per year [for XLI], you can get a fund whose returns have been 93% correlated with PHO.

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