Six ways to profit from investing in water - the next big 'super-trend'

  • Water demand rising; the sector needs more capital
  • $1 invested in clean water and sanitation returns $19
  • Way into water include Pictet Water and iShares Global Water

If you've seen The Big Short, or read the Michael Lewis book on which the film is based, you'll remember Michael Burry, the first of a small group of investors to start betting on the credit market's collapse in the run-up to the financial crisis.

When the storm eventually broke, Burry, played by Christian Bale in the film, made almost $1 billion, but that wasn't the end of his story. A closing credit revealed: 'Michael Burry is focusing all of his trading on one commodity: Water.'

In other words, the man who spotted the credit crisis coming before anyone else is now betting the house on another opportunity. And this time, more investors should listen to him - for there are compelling reasons to believe water will be one of the big stories of the years ahead.

The tale will be one of ever-increasing demand and dwindling supplies. Already, rapid population growth, particularly in developing nations, is driving a surge in demand - not just for drinking water and supplies for people's everyday use, but also for water-intensive industries such as agriculture and energy production.

This trend is intensified by urbanisation, with people all around the world moving into cities and demanding more water in concentrated locations.

As for supply, climate change threatens to wreak havoc, with extreme weather events increasing in frequency, flooding and drought on the rise, and water-rich nations eager to preserve their resources, often at the expense of what reaches other countries.

This is not simply a developing world problem. In Western Europe and North America, one in three people now live in areas characterised by the United Nations as having 'water stress'.

Earlier this year, the World Economic Forum ranked water crises as the third-greatest risk now facing the world. The Pacific Institute has noted a fourfold increase in violent confrontations over water during the past 10 years.

Some investors may feel uncomfortable seeking a profit from this theme, but the counter argument is that this is a sector in need of capital - indeed, water-related stocks are a mainstay of many socially responsible investment funds.

The broader economic opportunities that flow from clean water, moreover, are of broad societal benefit: the World Health Organisation estimates that the economic return of every $1 invested in water and sanitation is $19.

As for investors, any mismatch between supply and demand creates opportunities.

It is already doing so: the S&P Global Water index, a basket of shares in 50 water-related companies from around the world, has delivered annualised returns of almost 14 per cent, including dividend payments, over the past five years. By contrast, the FTSE All-Share index has struggled to deliver half as much.

Interestingly, moreover, these returns have been achieved without requiring investors to take on additional risk. An analysis just published by Schumann Capital, a US hedge fund that plans to bring a new water fund to market later this year, looked at the performance of the global water sector since 2004.

Not only have stocks in the water industry outperformed, but they have done so with lower levels of volatility than most other global stock market indices.

Hugo Rogers, manager of the Liontrust GF Global Water & Agriculture fund, a new fund launched in January but not widely available on retail fund platforms, argues that the big picture numbers are compelling.

'Hygiene requirements, easy accessibility and demand for manufactured goods mean the typical urban consumer uses four times as much water a day as their rural counterpart - 500 to 800 litres against just 60 to 150,' Rogers says.

'With 60 per cent of the world's population predicted to live in cities by 2025, up from just 15 per cent in 1900, we think water demand will grow at more than 3 per cent annually over the next decade; at the same time, water sources around the world are increasingly depleted and polluted, and prices have recently been rising at to three times broader inflation.'

'From an investment point of view, water gives you access to a secular growth opportunity compared to global equities,' argues Arnaud Bisschop, senior investment manager at the Pictet Water fund.

'On top of that, you have a really low overlap with global equity indices - you actually access an untapped market.'

Funds such as those run by Bisschop and Rogers invest in water in a variety of ways. Core holdings will include traditional water utility businesses, which in many countries provide a stable, if not spectacular, return profile because operations are highly regulated.

These holdings often generate strong dividends, and, says James Smith, the manager of Premier Energy & Water investment trust, 'offer fairly high visibility of returns over five years or more', with the regulator setting prices for extended periods. Such predictability is reassuring for investors.

In addition, many water funds invest in the business of water technology - anything from smart metering firms to infrastructure development. This provides potential for more racy returns - 'we aim to capture the long-term growth of the water opportunity [through such companies],' says Bisschopp.

Some of those technology plays, by the way, are fascinating. One area tipped by water experts as a potential 'next big thing' is purification: in the Middle East, in particular, huge investments are being made in graphene-related technologies, where undrinkable water is filtered and screened in order to make it fit to drink.

Environmental investment is a third theme for fund managers, who seek opportunities in areas such as sustainability, pollution control and waste. This can be particularly lucrative given the extent to which governments are now focusing on these issues.

The European Union, for example, has passed a series of directives committing members to improving water quality and reducing pollution. In China, water use and pollution are key focuses, with targets such as reducing usage by 30 per cent for every new dollar of industrial output.

In other words, while people sometimes describe water as a commodity, the investment opportunity mostly lies in the products and services that have developed around it.

There are investors out there who trade in water rights - the ownership of water sources; but leaving aside the ethical considerations of controlling the sale of such a basic human need, the practical problems around transportation make such assets less attractive than one might imagine.

ECLECTIC HOLDINGS

Fund managers' holdings can nevertheless be eclectic. Pictet Water's top 10 holdings, for example, currently range from household names such as United Utilities and Severn Trent, to Xylem, an American water technology company, and the water heater manufacturer AO Smith.

It was also an investor in Polypipe when the business was still unquoted.

And technology is rising up the agenda. 'More and more companies are coming forward with new technologies, for example, to improve leak detection or quality monitoring,' adds Bisschop.

This sort of diversity may provide some protection from what Mark Dampier, the research director of Hargreaves Lansdown, describes as the 'generally unhappy' history of funds that specialise in a single theme.

'Water sounds one of those great themes, and it may be, but single-sector funds normally display huge volatility, which most investors hate,' Dampier warns. 'These funds are hot one moment and freezing cold the next, as the theme comes in or out of fashion.'

It's a reasonable point, but water funds do provide geographical diversity, invest in both small and larger companies, and take stakes in defensive utilities as well as potentially high-growth technology businesses. They're not one-trick ponies.

This is not to suggest, however, that focusing on water is risk-free, even through a well-diversified collective fund. While the long-term dynamics underpinning the case for investment in the industry may be difficult to argue with, water is not immune to short-term ups and downs.

'Even amongst utility players in regulated sectors, there is scope for surprises,' says Smith. 'Not all companies are run well, plus there are the uncertainties of negotiating the next pricing round with the regulator.'

In the technology sector, meanwhile, development setbacks can hit valuations, while environmental investments may rise or fall according to the prevailing political arguments of the day.

Nor do water stocks escape broader market sentiment - the S&P Global Water index, for example, fell by more than 40 per cent in 2008, along with the rest of the financial crisis-afflicted market. There have been further down years since then, including a 9 per cent slide in 2011.

This may be another argument for an actively managed approach to investing in water. While both passive and active specialist funds are available, David Richardson, a director of Impax Asset Management, the environmental specialist which provides exposure to water stocks through several of its funds, argues for the latter.

'Due to the higher trading volumes they require, water sector ETFs tend to be dominated by the larger, more liquid companies, particularly the lower-growth utilities.'

Richardson continues: 'In contrast, the smaller-cap, pure-play stocks that specialist fund managers can identify, value and access open up further growth opportunities in emerging technologies.'

So, while a passive fund may give you exposure to the defensive qualities of water - valuable in itself - active management is more appropriate if you also want the higher-risk but potentially outperforming growth stocks.

WILL WATER BE THE OIL OF THE 21ST CENTURY?

Some investors and economists believe water has the potential to become a traded commodity, just like oil - and that, over time, a globally integrated market for trading water as an asset will develop.

And while this might seem a bizarre concept today - not least because of the ethics of trading in something so intrinsic to human life - it is attracting support.

'Once the spot markets for water are integrated, futures markets and other derivative water-based financial instruments - puts, calls, swaps - both exchange-traded and over the counter, will follow,' Willem Buiter, the global chief economist of Citigroup has argued.

'There will be different grades and types of fresh water, just the way we have light sweet and heavy sour crude oil today.

'Water as an asset class will, in my view, become eventually the single most important physical-commodity based asset class, dwarfing oil, copper, agricultural commodities and precious metals.'

There would certainly be practical problems with such an idea - water, affer all, is not easily transportable over long distances.

But bear in mind that while 70 per cent of the globe is covered in water, just 0.007 per cent of the stuff is currently fit for human consumption - in other words, the demand and supply dynamics are the classic stuff of free-market economics.

SIX WAYS INTO WATER

iShares Global Water

This London-listed exchange traded fund tracks the performance of the 50 stocks in the S&P Global Water index.

PowerShares Global Water

Listed on Nasdaq, this ETF tracks Nasdaq's alternative Global Water index, which follows a smaller basket of shares than its S&P equivalent - just 35.

Liontrust GF Water and Agriculture fund

Launched in January, the Liontrust fund promises a concentrated portfolio of 35 to 40 stocks chosen from the water industry, but also from agriculture, where similar demographic and economic themes are at play.

Pictet Water

Pictet's actively managed fund is the longest established specialist water vehicle available to UK investors, and currently holds around 60 stocks chosen from a universe of around 800 global companies the fund has identified as potentially suitable.

Premier Energy and Water Trust

This investment trust holds water stocks from around the world, with a particular emphasis on utility businesses, but also considerable emerging market exposure.

A yield of 4.9 per cent on the fund's highly geared ordinary shares will be attractive to income seekers. Premier also manages a parallel open-ended fund, Premier Global Utilities Income, run slightly less aggressively.

Impax Environmental Markets

This investment trust isn't a pure-play water fund, but offers exposure to the sector through a broader remit to back businesses with the potential to deliver cleaner or more efficient basic services.

Around 22 per cent of the fund's current holdings are held in water-related stocks, with further exposure coming from investments in pollution control.

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