Water: Liquid Gold

If you think oil is precious, what wouldn't you pay for water? Yet the World Health Organization estimates that 1.1 billion people (of six billion on Earth) lack safe drinking water, and half of all hospital beds in the world are filled with people suffering from water-related diseases.

What's new is that economies in many developing nations, such as China and India, are growing wealthy enough for them tackle their water problems. And that spells opportunity for companies in the U.S. and other developed nations.

Water is already a $420 billion-a-year global industry. Growth is also taking place in developed nations, which seek to make water safer from pollutants and more readily available in areas of shortages. In the U.S. alone, new water facilities are expected to cost $650 billion over the next two decades.

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Difficulty investing

The troublesome piece is how to invest in that growth. For fund and stock investors, the options are limited. Many of the biggest players in the water industry are conglomerates that earn only a tiny percentage of their profits form water. Think General Electric, Emerson Electric and Siemens AG.

Nevertheless, Steve Hoffmann, who runs WaterTech Capital, a merchant and investment banking firm in Plano, Tex., has constructed an index that offers a way to invest in water. Still, because the conglomerates dominate parts of the water industry and because of how his Palisades Water Index is constructed, it isn't ideal. PowerShares Water Resources Portfolio (symbol PHO), an exchange traded fund, mirrors his index.

I'll admit to a bit of inconsistency for writing even semi-positively about this ETF. That's because I've been dumping on the ETF industry for slicing and dicing the stock market into a bewildering array of niche products -- and then overcharging for them. This ETF's expense ratio of 0.60% a year is high for a product that simply mirrors an index. And the water ETF is certainly narrow. Water, however, may be worth just a bit of your long-term money. "This is the water industry's best benchmark," Hoffmann says.

But shame on PowerShares for the graph on its Web site that implies that the index would have turned $10,000 into $28,000 over the past six-plus years. The graph relies on hypothetical back testing (which you can read about if you bring along a magnifying glass). Anyone can achieve great results with back testing -- that is, selecting a stock-picking system and seeing how it would have done in the past. Besides, Hoffmann readily concedes, his index will rise and fall with stocks of small companies, which have excelled for most of the past six years. Launched late last year, the ETF has gained 10% this year.

Hoffmann uses a complex and, frankly, weird methodology to construct and manage his "dynamic index." He starts by identifying all companies that derive more than half their revenue from water-related industries. He includes only stocks with at least $150 million in market value, sufficient trading volume and trade on a U.S. exchange. That permits inclusion of some of the more liquid (forgive the pun) foreign firms that offer American Depositary Receipts. These stocks make up at least 80% of the index. The rest of the index contains conglomerates that are big players in water. No stock can account for more than 5% of the index. So far so good.

But next he divides the stocks into six sectors. The sectors and their current weightings in the index are as follows: water utilities, 23%; water treatment, 20%; analysis and testing of water, 7%; water companies that do many or all of these things, 17%; water infrastructure, 18% and conglomerates, 15%. The index currently has 38 stocks.

On a quarterly basis, Hoffmann tweaks the weightings of each sector in the index according to his big-picture view of how the sectors will behave in the coming months. But within each sector, each company gets exactly the same weight at the start of every quarter. So while Hoffmann makes no changes in the index based upon his view of the outlook for individual companies, their weight in the index will change -- depending on how many stocks are in each sector and how he weights each sector. He says he has no neutral weighting for the sectors -- in other words, no preset way to position the index if he isn't particularly bullish or bearish on any of the sectors.

Got it? I'm not sure I do. Still, the ETF is as good a way as there is to make a diversified investment in water stocks.

If you prefer individual stocks, Hoffmann likes Aqua America (WTR), a big consolidator of privatized local water utilities. The downside: Like most utilities, regulators dictate what water utilities can charge. Among companies in the water treatment area, Hoffmann is a fan of Pentair (PNR) and ITT Industries (ITT).

He also likes Layne Christensen (LAYN), which drills water wells and is expanding into other areas. Another favorite is Lindsay Manufacturing (LNN), which develops irrigation systems.

As for me, I'm a confirmed fund junkie. So, despite its many warts, the PowerShares ETF still holds appeal. But a drop or two is all you'd want. After all, there are lots of other ways to play emerging markets.

Steven Goldberg is a freelance writer and former senior associate editor of Kiplinger's Personal Finance magazine.