Holy Water II: A Place of Its Own

How to see the Water Investment Opportunity as an asset class in its own right is the discussion of the second installment of the investment series: Holy Water. It discusses how the investment theme can be seen as an alternative to fixed income and can bring new spaces of risk-returns to a financial portfolio. It also shows the differentiation within the space in terms of its funds and how a good selection is important to access its best opportunities.

A New Route for a Sustainable Yield

I discussed in the first episode of this series that the water trade was the opposite side of “the kick the can down the road”. That is an opportunity that only gets bigger the longer it is delayed until it will inevitably have to be done (at a greater cost). This can be seen as a long-term fixed income to whoever is ready to provide the financing to solve water challenges. It has a floating coupon based on growing environmental and governance issues, and the principal repayment is ensured by the inevitability of new infrastructure investments. It is also the business of the handyman that has a full pipeline ahead of fixing the society’s pipes given how demographics and climate are evolving. Seeing the trade as such allows investors to consider new investment spaces for their portfolios by readily integrate the theme at an asset class level.

Traditionally, allocations have been divided by asset classes. Markowitz has elected portfolio construction through the division of financial instruments and optimised their allocations by their historical performance. What has become financial theory - to almost to a point dogmatism - is now ruling most of institutional allocations. This type of portfolio construction is allocating capital based on the historical behaviour of these financial instruments. It however makes much more sense to define your portfolio on forward-looking economical factors, such as the need for water solutions in the next 10, 20 or 50 years. The water investment theme is therefore an asset allocation driving on society's water needs for the foreseeable future.

Water funds have been the first products to ride this early wave and rewarded their investors with substantial returns over the last decade. This allocation proved to deliver a stable stream of income that challenged most credit investments for the very definition of “fixed income". The following chart shows indeed that the best Water funds outclassed an array of credit indices in terms of steadiness of performance:

Source: Koyfin, SwissFundData, Yahoo. All credit indices' performance are represented by the performance of their generic ETFs. 

This shows the potency of the space to be a stable source of income in a portfolio and be regarded as a fixed-income substitute. As many institutional investors know, the search for yield has been a challenging journey since the central banks started to depress rates and provide markets with boundless liquidity. This search has pushed them to venture into new spaces such as private equity and other alternatives, where liquidity, transparency, or up-to-date pricing were often offered in exchange. The water investment theme offers a new route through small-mid cap equities. The classical water equity space is indeed a collection of niche equities constantly working on providing solutions to water infrastructures. This implies multiple sources of independent performance amounting to an inherently diversified allocation when bundled together.  This translates into a steady performance for investors and can become an investment driver in a portfolio. The theme deserves the title of fixed-income more than any debt instrument seen in the last decade.

Its Own Path

This comes however with its own price, with a volatility still being equity-tuned. But one could help to wonder if that such a bad of a thing. In the literature of risk measures, volatility is often depicted as flawed and one-sided. A more acute measure of risk, in my opinion, is the time below water. That is the time you are not growing and making up for what you have lost. This is what the real problem is for most fixed-income investors whose Asset Liability Management depends on their assets to deliver.

This can be seen in the next chart where water funds have actually spend much more time above water (no play of words intended), with their steady performance amending their periods of losses and allowing them to be in the green a larger portion of the time:

Source: Koyfin, SwissFundData, Yahoo. Chart done in R.

This chart shows that water funds are delivering new sources of income 30 to 40% of the time. This compares to 5-20% for classical fixed income benchmarks, implying they are not delivering income 80 to 95% of the time. There is therefore much more capital protection in seeking growth than safe heavens. The investment theme is being carried by strong fundamentals that are being ever more relevant given the lack of water infrastructure reinvestments, climate risks and demographics changed. These are resources for the allocation to capitalize on in the future and act as embedded protection within the theme.

Accessing New Places

The water investment theme, here captured by its funds, is therefore a sustainable source of income for any kind of investors. It can be considered as a new alternative for fixed income as presented previously, a growth-like equity addition, or simply as a stand-alone alternative. The allocation is indeed versatile enough to be considered in various parts of the portfolio. This is for example interesting for institutional investors wishing for an alternative source of yield but who are restricted by regulation in their allocation. This theme can be put into their equity books compared to other alternatives that require to be considered as such; being therefore potentially limited by additional restrictions. For a family office or independent investors, the theme can become an allocation at an asset class level, reducing the weights of other classes and being its own source of performance and diversification.

The following chart shows the performance of 4 different portfolios depending on where to consider the water theme from a classical 60/40 Equity/Bond portfolio: either not at all, as fixed income, as equity, or as an alternative. This yields 4 portfolios with respective weightings 1) 60/40/0, 2) 60/20/20, 3) 40/40/20, and 4) 50/30/20 of 3 generic assets: IG Index, MSCI ACWI, and a Water Fund.

Source: Koyfin, SwissFundData, Yahoo. Chart done in R.

This chart shows that the water fund increases the performance of any portfolio wherever it is considered in the books. Water funds have therefore the capacity to change portfolio characteristics and provide new spaces of risk-return. This is further shown in the summary table of these portfolios below, where the water fund allowed to favour either the performance or the protection of the portfolio depending on where it was considered:

A Complex Space

This differentiation however comes from a small set of water funds who are best able to allocate through the various industries of the space and capitalise on their different dynamics. The following chart shows the room for active differentiation.

Source: Koyfin, SwissFundData, Yahoo. Chart done in R.

This chart shows that out of the entire peer group, 5 water funds are stealing the show by displaying higher performance, lower volatility, and lower correlation to global markets (represented by the sizes of the of any given dot with their given values). These 5 funds in the lower right quadrant are currently the best selections to make the most of the water investment opportunity. They are best able to navigate the space between its various sectors and capitalise on different market dynamics; shifting for example from protective Utilities to growth-induced Industrials to adjust for the cyclicality of the allocation. 

My analysis The Water Investment Opportunity through Fund Selection (Complete Edition) looks more deeply at the differentiation in the space and provide more details on these funds (names, IDs, sustainability ratings, and other Infos). It is available on-demand or soon on Refinitiv Eikon Platform.

But a Solution

Water funds are therefore a good way to access the water investment opportunity and represent a versatile allocation that can suit many parts of a portfolio. It changes its risk-returns characteristics and allows managers to consider new spaces of risk-returns by aligning their portfolio on forward-looking economical drivers based on climate change and rising demographics. This opportunity can be further explored through single stock selection, venture capital, or water-linked investments. These topics will be each further explored in their own installments in these series.

Disclaimer

The information contained on this article is provided for information purposes only. It should not be construed as investment advice and is subject to change without notice. All statements and expressions are the opinion of Nicola Lei Ravello and are not an offer or solicitation to buy any financial services or financial instruments.

Investors should bear in mind that investing in securities, mutual funds, hedge funds, private equity funds or similar investment products as well as investing in foreign currencies is highly speculative and carries a high degree of risk. Any investment can result in the total loss of assets. Past performance is no guarantee of future performance and the value of investments can fall as well as rise, especially over the short term.

Nicola Lei Ravello does not warrant or make any representation as to the accuracy or completeness of any information expressed on this website. Nicola Lei Ravello does not accept any responsibility for any loss which may arise from the use of the information on this website.

? Nicola Lei Ravello, White Stag Investing, 2020. Zürich, Switzerland.

www.whitestaginvesting.com