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Investors are pouring into water-related exchange-traded funds, but those looking to support environmentally sustainable companies may be unwittingly buying into stocks that don’t necessarily help preserve the dwindling resource.

Some companies in water ETFs do not align with investor definitions of socially responsible. If a company generates even a small portion of its business from water-related activities, it could be included in a water investment product.

“When you look at some of the climate change-related ETFs, you’d be surprised about some of the companies that are included,” says Hyewon Kong, a portfolio manager at Toronto-based AGF Investments Inc. who is focused on environmental themes.

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At the centre of water investing is the increasing need to upgrade infrastructure and technology that treats and transports the resource. As the global population grows, and environmental risks worsen, demand for clean water is expected to rise – putting pressure on water systems.

The issue – and potential investment opportunity – has grabbed investor attention. As more money flows into environmental, social and governance (ESG) investing, water is at the forefront. Water ETFs attracted more investment in the first nine months of 2019 than any full year since 2007, according to data by Bloomberg.

“Water is the new oil,” Ms. Kong says. “In the past, water was disregarded as an abundant source, but it isn’t any more. Climate change has really made an impact on water investing.”

ETFs that invest in water-related stocks, including Invesco Water Resources ETF (PHO-Nasdaq) and First Trust Water ETF (FIW-NYSE-Arca) are outperforming the broader index. Each of these ETFs rose more than 23 per cent over the past year compared with the S&P 500’s 19.7-per-cent climb as of Nov. 26, according to Bloomberg.

Overweight in utilities and industrials, the funds include companies that manage drinking-water and wastewater systems, such as American Water Works Co. Inc. (AWK-NYSE); build infrastructure and pipeline construction, such as Aegion Corp. (AEGN-Nasdaq); and treat and test water, including Xylem Inc. (XYL-NYSE).

While these types of companies are affected by water issues, many are not directly involved in improving efficiency or sustainability. Most large utility and industrial water companies are tied up with patching worn-out infrastructure, said Matt Sheldon, a Boston-based senior portfolio manager in water strategy at KBI Global Investors Ltd.

Mr. Sheldon says many smaller companies focused on new approaches to irrigation, engineering and construction with strong valuations are often left out of water ETFs and indexes. Instead, the funds take large positions on big companies, some of which have little exposure to water solutions.

Olin Corp. (OLN-NYSE), a global chemicals manufacturer, is included in both iShares S&P Global Water Index ETF (CWW-TSX) and Invesco S&P Global Water Index ETF (CGW-NYSE-Arca). While the company produces chlorine, which is used to treat public water, its business stretches as broadly as manufacturing of guns and resins used in paint.

Science and technology companies such as Danaher Corp. (DHR-NYSE) and Idex Corp. (IEX-NYSE) – up 41.8 per cent and 24.9 per cent, respectively, over the past 12 months according to Bloomberg – typically occupy relatively large positions in water ETFs, with the two companies making up 15 per cent of the total holdings in PHO. Both companies are engaged in water activities, including purification and pumps, but these segments are only a portion of their businesses.

“If you’re looking at this from an ESG perspective, then you’re generally owning something different than what you would have hoped to have owned in a water strategy,” Mr. Sheldon says. “The better risk-reward opportunities with higher impact and engagement might be with the smaller companies that are underrepresented, or not in these ETFs at all.”

While some investors consider water ETFs from a sustainability and efficiency perspective, large public water-related companies are currently focused on creating the infrastructure needed to manage changing water flows and the effects of climate change, said Mark Yamada, president and chief executive of Pur Investing Inc. in Toronto.

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“Water, like every other ESG issue, is poorly defined,” Mr. Yamada says. “The practical issue that has come upon us right now is about how we handle rising water levels, like creating barriers, moving houses to higher ground and flood diversion. These are things that have nothing to do with creating clean water.”

But Mr. Yamada said that water ETFs are still one of the best ways to invest in the sector, as the industry will eventually need to adopt new technology and it’s still too early to know whether innovation will come from smaller companies or the larger enterprises.

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