[ETF] 2 Water ETFs to Diversify your Portfolio

Remember Michael Bury from the Wolf of Wall Street?

After predicting the collapse of the financial markets, he declared his intention of investing in water. In hindsight, this appears like an inspired bet: While 70% of the Earth is covered in water, fresh water only accounts for 2.5% of it and the United Nation estimates that “over 2 billion people live in countries experiencing high water stress“.

The law of supply and demand states “that when an item is scarce, but many people want it, the price of that item will rise“.

Investors interested in diversifying their portfolio, here’s are 2 water-focused ETFs that you should look into:

While these two ETFs focus on the same sector, they adopt two different approaches to balancing their index, which results in different risk/reward opportunities. The images below, taken from etf.com‘s [very useful] ETF comparison tool, compare the main aspects of each ETF.

Facts

PHO and FIW are both “modified market capitalization-weighted indexes comprised of exchange-listed companies who derive a substantial portion of their revenues from the potable and wastewater industry”. Translated into English, this means that both indexes are portfolios composed of public company stocks who operate in the water sector.

The first things we are looking at are the expense ratios, average spread and assets under management (AUM) of each index:

source: etf.com
  • ASSETS UNDER MANAGEMENT (AUM)

PHO’s AUM are more than double FIW’s: This is significant because ETFs with more AUM have higher trading volume and less daily spread. Spread is the difference between the bid price and the ask (selling) price. With AUM under $500m, FIW is theoretically at greater risk of seeing higher daily spread compared to PHO. Wide spread is especially problematic for short-term traders who survive on thin profit margins; for long-term investors, this is not an issue.

PHO’s average spread of 0.12% is only 0.02 percentage points lower than FIW’s average spread of 0.14%. In fact, the average difference in spread is only $0.04.

  • TRACKING DIFFERENCE

An ETF is designed to track the performance of a given index. The tracking difference is the difference between an ETF and its official benchmark total return on a given period. The Tracking Difference is net of management fees and administration cost. If index replication is perfect, the tracking difference should be equal to the ETF expense ratio.

PHO and FIW both track the S&P 500 Global Water Index.

Both indexes have a tracking difference in the -0.60% range. In this regard, both funds’ performance is below average compared to broad based ETFs. In comparison, the S&P 500 SPDR, one of the largest ETFs in the world, has a median tracking difference of just -0.16%.

etf.com
  • EXPENSE RATIO

An expense ratio is the annual cost associated with the management of the index: If the fund realizes an annual return of 5% and the expense ratio is 1%, then 20% of the investor’s total return is eaten up by fees. Thus, investors are careful to seek the lowest possible expense ratios.

PHO’s expense ratio of 0.60% is 0.05 percentage points higher than FIW’s ratio of 0.55%: The higher ratio may be justified by the greater AUM.

Both funds expense ratios are much higher than a traditional S&P 500 ETF, which usually have expense ratios inferior to 0.1%. These funds’ ratios are higher due to the sector-specific focus of the fund which takes more time to manage than a more general market tracking ETF.

Weighted scheme

Each ETF has its own criteria that stocks must respect to be included in the index. PHO and FIW “holds 36 of the largest US-listed water companies, ranked by market cap and weighted equally within five tiers“. Since companies’ markets caps fluctuate throughout the year, both indexes rebalance their portfolios twice a year.

However, PHO and FIW have adopted two different weighting strategies that reflect different investing philosophies.

  • PHO: SAFETY FIRST

PHO’s index is composed of 89.53% Large and Mid cap stocks, 9.96% Small cap stocks and just 0.51% Micro cap stocks. This is the choice of safety as larger cap stocks are well established businesses who generate stable returns and have limited growth potential, whereas small and micro cap stocks have greater growth potential but higher risk of failure.

PHO’s choice of composing its index mainly with larger cap stocks should theoretically result in lower but more stable returns.

etf.com
  • FIW: RISKY APPROACH

FIW’s index, on the other hand, is composed of 48.14% Mid caps, 26.57% Large caps, 22.71% Small caps and 2.58% Micro caps.

The main advantage of this strategy is the reduced concentration of a single cap size on the overall fund performance.

FIW’s choice of composing its index with lots of mid, small and micro cap stocks should theoretically result in higher returns. However, the risk of volatility is higher as the companies are theoretically less robust.

We will see if this theory checks out when we analyze performance.

etf.com

Portfolio – Diversification

  • INDUSTRY DIVERSIFICATION

Both ETFs have similar industry diversification, with small differences:

  • FIW has a greater share of industrial and utilities stocks
  • PHO has a greater share of healthcare, basic materials and consumer cyclical stocks.

These choices are the result of each ETF’s weighting strategy.

etf.com
  • GEOGRAPHICAL DIVERSIFICATION

Both indexes are composed of more than 97% American equities.

This means that this index is extremely sensible to the American economic climate. The small exposure to Brazilian markets provides very little hedge against this risk, especially when we consider just how sensitive and prone to downturns the Brazilian economy is.

etf.com

Portfolio – Top 10 Holdings

Both EFTs basically own the same stocks. However, due to their different weighting approaches, the indexes hold different amounts of the same stocks.

Considering that PHO is essentially composed of Large cap stocks, it is natural that its top 10 holdings weigh 62.41% of its total portfolio whereas FIW’s choice of balancing its holdings more evenly results in its top 10 holdings only weighing 41.61% of its total portfolio.

etf.com

Performance

While both stocks’ performances are similar, the bottom line confirms the assumptions we made in the “Weighted Scheme” section: FIW’s choice of composing its index with a larger share of small and micro caps has resulted in significantly higher 10 year returns.

The only positive aspect of PHOs strategy is that the index does not dip as much in times of trouble, with slightly better YTD performance.

etf.com

Portfolio Data

  • Dividends: FIW pays a better dividend then PHO.
    • PHO has a dividend yield of 0.69%
    • FIW has a dividend yield of 0.96%.
  • P/E Ratio: FIW’s P/E ratio is higher than PHO’s.
    • PHO’s P/E ratio is 31.73
    • FIW’s P/E ratio is 39.26
  • Price to Book Ratio: FIW has a better P/B ratio than PHO.
    • PHO’s P/B ratio is 4.34
    • FIW’s P/B ratio is 3.79

In sum: FIW pays a better dividend and has a lower price to book ratio than PHO but PHO has the better P/E ratio.

MSCI Rating

The MSCI ESG Ratingsmeasures the Environmental, Social and Governance (ESG) characteristics of portfolio holdings“. This rating is based on other metrics than price performance and was developed in response to the rising “demand among wealth and asset managers for greater investment transparency driven by a desire to better reflect their investment views and values“.

The main criteria are exposure to sustainable impact solutions and weighted average carbon intensity of the index’s stocks.

  • PHO receives AA rating, with a total MSCI Quality score of 8.02/10.
etf.com
  • FIW receives an A rating, with a total MSCI ESG Quality Score of 7.03/10. FIW ranks worse than PHO on all metrics except weighted average carbon intensity.
etf.com

Conclusion

In my opinion, both of these ETFs present interesting opportunities for investors looking to diversify their portfolios. However, the indexes’ different approaches in weighting company cap sizes have a significant impact on their performance and exposure to risk.

While FIW has performed better than PHO over the past 10 years, the current coronavirus-induced crash will prove to be a real test to its weighting model: Will the Small and Micro cap stocks of FIW’s index be able to recover from the incoming economic crisis and provide similar returns as they have in the past? Or will PHO’s large cap heavy portfolio prove more resilient?

While I find FIW’s past performance enticing, the current economic context pushes me to favor PHO’s large cap fund. However, if the economy returns to normal fairly quickly, then my money will go to FIW.

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Disclaimer: This is not financial advice. Do your own research before investing.

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