Water may seem like a strange investment on the surface, given the vastness of the world’s oceans, but water scarcity has become a very real global concern. According to UN Water, global freshwater usage has been increasing at more than twice the rate of population growth, and freshwater scarcity is widely cited as a reason for future geopolitical conflicts.

Investors can’t simply purchase water futures contracts — as they could with crude oil or natural gas — but there are opportunities to invest in water-focused corporations. For example, industrial water treatment and purification companies are a critical supplier of freshwater for human consumption and farming, while water equipment and delivery companies provide alternative ways to capitalize on the rapidly growing market.

In this article, we will take a look at exchange-traded funds (ETFs) that are focused on water, their performance over the past several years, and some important risks to consider.

Many water-focused ETFs have outperformed the S&P 500 over the past year. In fact, the PowerShares Water Resource Portfolio (PHO A-) has risen nearly 12%, the First Trust ISE Water Index Fund ETF (FIW A) has risen over 21%, and the Claymore S&P Global Water Index ETF (CGW A+) has risen more than 10% over the past year. These returns are significantly high when compared with just over 5% for the SPDR S&P 500 ETF (SPY A) over the same time frame.

Figure 1 – Water ETF Performance – Source: Google Finance

Water ETFs tend to perform well during uncertain economic times, since they consist of safer “blue chip” equities such as industrial water treatment plants. On a macro level, this means that water ETFs may represent a good hedge against market declines as a defensive portfolio element. The downside is that they may underperform during bull markets when investors are seeking to invest in riskier growth sectors such as technology.

The PowerShares Water Resource Portfolio (PHO A-) is the largest ETF in the category with about $710 million in assets under management and a 0.61% expense ratio. Some of the fund’s largest holdings include American Water Works Co. Inc. (AWK), a water and wastewater utility with a 1.8% dividend yield, and Danaher Corp. (DHR), an equipment producer that makes products to protect the water supply.

The First Trust ISE Water Index Fund ETF (FIW A) is a smaller option with approximately $140 million in assets under management, but it’s also cheaper with an expense ratio of just 0.57%. The fund’s largest holdings include Pentair plc (PNR), a leader in water, fluid, and thermal management and equipment, as well as American Water and Danaher. It’s also worth noting that the company holds a less concentrated portfolio than PHO.

A third option is the Claymore S&P Global Water Index ETF (CGW A+), which has about $415 million in assets under management and a 0.64% expense ratio. Unlike the two aforementioned ETFs, the Claymore fund holds a greater percentage of global water companies, including Geberit AG (GBERY), which is a Swiss manufacturer of sanitary parts and related systems used for European water treatment.

Finally, the PowerShares Global Water Portfolio (PIO B+) rounds out the options for investors, with about $200 million in assets under management and a 0.76% expense ratio. With a year-to-date return of just over 5%, the fund is both the worst YTD performer of the group and the most expensive fund in the space.

Water ETFs are a great way to play the long-term issues facing the global freshwater supply, but there are some important risk factors to consider.

The most important risk factor is that the major catalysts behind water scarcity could take decades to materialize, which means that investors must wait a long time for the true investment thesis to play out. In the meantime, investors may suffer from below-market returns or possibly returns that correlate more to the defensive nature of the stocks contained within many of these ETF portfolios.

Investors should also carefully consider the expenses associated with these ETFs, which are significantly higher than many low-cost broad market funds. In many cases, these expenses can take a bite out of long-term returns and raise the bar to meet market benchmarks.

Water scarcity is a long-term problem that’s likely to affect the global population, but it could take decades for the problems to translate into above-market performance for equities. The upshot is that many water ETFs provide exposure to defensive equities that may outperform during periods of economic uncertainty. Investors should carefully consider the risks, however, before taking a position in these ETFs.