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Water exchange-traded funds (ETFs) have been among the strongest performers on the market over the past year, and as a sustainability-linked investment theme with a compelling long-term scarcity story, have obvious appeal as a way to diversify a portfolio.

But with valuations across the broader market looking stretched and questions about the degree to which water ETFs truly fit the environmental, social and governance (ESG) umbrella, investors need to do their homework and consider whether the timing is right before buying.

The big-picture appeal of water as an investment space has been a growing story over the past few years as the reality of climate change threatens to increasingly stretch freshwater resources.

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“It’s going to be a growth market because clean water is a growing problem and it’s going to be an accelerating issue in coming decades,” says Mark Yamada, president and chief executive of Pur Investing Inc. in Toronto.

While the water space may be seen as a long-term play, it has produced impressive short-term results over the past year. In North America, it’s dominated by three large funds, each of which has produced 12-month returns of around 30 per cent to 40 per cent, compared with a return of just under 30 per cent for the benchmark S&P 500. (All data as of Oct. 6 close).

The Invesco Water Resources ETF (PHO-Q) tracks the Nasdaq OMX US Water Index, holds some US$1.9-billion in assets, and is up about 36 per cent over the past year. The First Trust Water ETF (FIW-Q), which has assets of US$1.3-billion and holds 36 of the largest U.S.-water companies, is up about 40 per cent over the same period. The other billion-plus water ETF is the Invesco S&P Global Water Index ETF (CGW-A), which holds about US$1.1-billion of the largest global water-related companies, and is up 35 per cent in the past year.

There is also a smattering of smaller funds, including the lone Canadian entrant, the iShares Global Water Index ETF (CWW. TO-T), which, like Invesco’s CGW, has a global focus. It has assets of around $325-million, and has risen about 28 per cent over the past year.

Picking apart the reasons for their recent strength is tricky, but one likely driver is the promise of some US$55-billion in water sector investments that are part of the U.S. infrastructure bill announced in June, but still waiting for approval in the U.S House of Representatives.

But the sector has also been boosted by the rush of capital into ESG funds and other sustainable investments, fuelled in part by ever more dire news on climate change.

“No doubt that the psychology has shifted over the last 18 months,” says Tim Nash, founder of Good Investing Financial Planners Ltd., a Toronto-based financial planning firm specializing in sustainable investing. “During the COVID crisis, climate change has remained top of mind for investors and valuations of companies that are a hedge to climate change have gone up.”

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But while the water sector would seem like an obvious destination for ESG investment, not all ESG funds are created equal, sustainability-wise, and a look into their constituents reveals companies that at first blush might seem out of place.

Part of the issue is that it isn’t as easy to identify pure-play companies for a water ETF the way you can find copper miners for a copper fund. While the water ETF space includes companies involved in water purification and developing sustainable resources, such as through pumping equipment, there are also large holdings of utilities and pipe manufacturers, some of which have operations beyond the water industry.

“The companies that build the infrastructure like pipes or plumbing equipment, clearly if you want a pure-play, you might not want to own that but rather own things that are involved in the supply of water, water utilities, treatments and purification. That’s why I think it’s important to look at the securities that are inside of some of these ETFs,” says Deborah Fuhr, managing partner and founder at independent research firm ETFGI LLP.

For instance, one of the largest holdings for several of the ETFs is Danaher Corp., which includes water purification as only one of many health-focused business lines.

Another issue is that while water supply is a sustainability issue, not all the companies in water ETFs score well through an ETF lens, says Mr. Nash of Good Investing.

“When we look at water ETFs through an ESG lens, a couple of things emerge: Number one is they often have a very high carbon footprint,” he says. “Because a lot of these are water utilities, they do tend to be more energy-intensive and, because these are often diversified companies, they sometimes do own some energy-generation facilities.”

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The only water ETF that bills itself as an ESG investment is the Ecofin Global Water ESG Fund (EBLU-N), which is one of the smaller offerings with about US$55-million in assets. It has risen by about 30 per cent over the past year.

Experts say investors should look into the constituents of any ETF they’re thinking of investing in and keep the portfolio allocation down around the 5-per-cent range.

“I think that if you’re building a portfolio from the top down – in other words, you’re starting with your asset mix and then you’re starting to look at diversification by sector – I think people would look at a water ETF in portfolio construction as a satellite investment,” says Mr. Yamada of Pur Investing.

Despite the questions about the ESG credentials of the space, Mr. Nash includes water ETFs in his allocation of “doing more good” investments. And whether or not the gains of the past year are sustainable, he sees good long-term prospects in a world where climate change will only grow as an issue.

“It makes sense that governments are going to need to invest in climate adaptation, which should result in greater revenues for companies that are in the water and infrastructure and utility space,” he says.

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