FIW: Still Expensive, But the Water ETF Is Trending in the Right Direction (NYSEARCA:FIW)

Investment thesis

I last reviewed the First Trust Water ETF (NYSEARCA:FIW) On July 16, 2023, it concluded that the water industry’s supply chain challenges and high ETF rating only warrant a ‘Hold’ rating. Since this article was published, FIW has lagged behind Invesco european water resources investment funds) and SPDR S&P 500 ETF (spy) by 1.44% and 5.56%, respectively.

I continue to look at FIW regularly because it can complement index funds like SPY well. However, FIW’s expense ratio of 0.53% is a major detractor, and I only want to participate in it when its fundamentals look too strong to ignore. That’s the purpose of today’s update, and I look forward to walking you through the latest numbers in detail below.

FIW Overview

Strategy discussion

FIW tracks the ISE Clean Edge Water Index, and selects 36 companies from which it derives Revenues from the drinking water and wastewater industry, specifically:

• Water distribution
• Water infrastructure (pumps, pipes, valves)
• Water solutions (purification, filtration)
• Ancillary services (consulting, construction, marketing)

An independent committee determines what the definition of “big” is, so readers should know it’s not just a play on the water. At each semi-annual rebalancing in March and September, the selections are assigned a security weight after sorting them by market value, as follows:

• Securities 1-10: 4%
• Securities 11-15: 3.5%
• Securities 16-20: 3%
• Securities 21-30: 2%
• Securities 31-36: 1.25%

Below are the top ten holdings, which total 39% of the portfolio. This group includes most of the largest companies by market capitalization, including the recent Danaher (DHR(Spin-off Feralto)VLTO), Ecolab (Expected credit losses), and Roper Technologies (Royal Oman Police). Missing is IDEXX Labs (IDXX), the fourth-largest security by market capitalization but FIW’s holding is No. 15. The stock has struggled since the start of the year, down 10.67%, but should become more valuable after a rebalancing in September.

Performance analysis

Since June 2007, FIW has generated a total return of 451.29% with dividends reinvested compared to 252.28% and 389.93% for PHO and SPY, respectively. On an annual basis, it is approximately 1-3% higher, and FIW’s risk-adjusted returns (Sharp and Sortino ratios) are much higher than PHO, its more direct counterpart. However, we can see how water stocks are more volatile than the broader market, and this additional volatility has not always been a positive. FIW’s risk-adjusted returns (Sortino ratio) were 0.82 versus 0.87 for SPY.

The above statistics describe 17 years of history, which can be difficult to draw conclusions from. Instead, I encourage you to view a chart of long-term returns for ETFs, because it quickly highlights periods when FIW has succeeded and when it has struggled. For example, for the three years ending May 31, 2024, FIW’s annual returns lagged PHO and SPY by 0.08% and 1.41%, respectively.

This chart reveals that the two water ETFs experienced a boom from 2011 to 2013 that was quickly followed by a crash in subsequent years. FIW returns were flat in 2014 (0.36%) and negative in 2015 (-10.01%), which management attributed almost entirely to the fund’s overweight industrial sector composition, he wrote in Annual Report:

The industrial sector contributed more to the relatively weak performance of the fund compared to the reference index. The fund suffered a decline of -5.8% due to an increase in its allocations to the underperforming sector by 48.3%.

This is a small example of the risks investors face when investing in non-diversified funds. Over time, it still works well, but it’s important to limit it to a small percentage of your portfolio and get a great rate. This is my primary goal with fundamental analysis, however Since coverage began Two years ago, I discovered too many weaknesses to justify purchasing SPY.

FIW analysis

Composition by sector and sub-industry

Before I evaluate these potential weaknesses, I want to highlight the differences in FIW configuration with PHO and SPY. As shown below, 56% of FIW is allocated to industrials, which is similar to PHO.

FIW owns stocks in 16 sub-industries of GICS, as follows:

1. Industrial machinery, supplies and components: 22.36%
2. Water utilities: 14.28%
3. Environmental and utility services: 9.21%
4. Construction products: 8.63%
5. Life sciences tools and services: 7.24%
6. Trading companies and distributors: 6.66%
7. Construction and Engineering: 5.54%
8. Electronic equipment and tools: 4.53%
9. Specialty chemicals: 4.09%
10. Applied software: 3.86%
11. Healthcare equipment: 3.31%
12. Research and consulting services: 2.87%
13. Soft drinks and non-alcoholic drinks: 2.71%
14. Multiple utilities: 2.04%
15. Commodity chemicals: 1.50%
16. Agricultural and agricultural machinery: 1.14%

WHO does not have exposure to sub-industries 11, 13, 14 and 15, so it is arguably less diversified than FIW. Finally, FIW is an effective complement to SPY, as there is only 0.75% overlap by weight. PHO’s overlap with SPY is a bit more at 1.93%, but regardless, the takeaway is that water stocks likely won’t be prominent in your portfolio. FIW and PHO are effective options.

Fundamental analysis FIW

The following table highlights selected key metrics for FIW’s 25 largest holdings, totaling 82.53%. This number is lower than PHO’s figure of 94.75%, supporting the argument that it is more diversified.

Here are two additional notes:

1. Since my last review, FIW’s estimated one-year EPS growth rate has improved from 10.99% to 12.05%. In addition, evaluation metrics have also improved. FIW trades at forward earnings of 25.49x using the simple weighted average method and 23.25x using the weighted average method, which is close to what you’ll see on websites like Morningstar. The fund also has a long-term (3-5 year) dividend growth rate of 10.56%, indicating that it represents strong growth for the foreseeable future.

However, the valuation of ETFs in this sector is high. For example, the Invesco S&P 500 Equal Weight Industrials ETF (RSPN) and the Invesco S&P SmallCap Industrials ETF (PSCI) trades 4-6 points cheaper and, in the case of RSPN, has a similar one-year earnings growth rate of 11.48%. As I wrote in October 2022Water is expensive, and FIW results have since supported the shift of funds away from SPY.

2. Quality is usually low with this size. However, FIW’s sector-adjusted profit score of 7.09, derived from research on alpha factor scores, improved from last year’s score of 6.68/10. Meanwhile, the SPY score fell from 9.43/10 to 9.32/10, so I’m glad to see the gap closing. In addition, FIW’s EPS revision score of 6.55/10 also improved from last year’s score of 5.59/10, indicating Wall Street analysts have turned bullish. Previously, I highlighted downward earnings revisions for Advanced Exchange Systems (WMS), but the stock is up 18.42% year-to-date and has beaten consensus earnings estimates for five straight quarters.

Investment recommendation

FIW’s fundamentals have improved since my review last year, specifically in terms of quality and valuation relative to SPY. However, its price is still high compared to other industry ETFs, and I’m not willing to pay the fund’s high expense ratio of 0.53% unless I’m confident I’ll get a great price. Since that is not the case today, I have reiterated my “hold” neutral rating on FIW and plan to check back next quarter with another review. thank you for reading.