Investors, however, see the flip side to such a scenario: Scarcity increases demand, which translates into opportunities. Driven by this optimism, hedge funds and mutual funds that invest in the global water industry in various ways are popping up like weeds. A number of water-themed exchange-traded funds (ETFs) recently debuted, and several banks now issue water-based structured notes—simple investment contracts designed to offer exposure to the water sector. Clearly, when it comes to water scarcity, the financial sector sees the glass as half-full.

The case for investing long term in water is compelling: Global demand for fresh water is rising exponentially because of population growth and rapid industrial expansion in emerging markets, along with demand rising faster than population growth in developed countries. According to the Department of Interior, water demand in the U.S. has tripled in the past 30 years, while the population has grown 50 percent. On the supply side, developed countries have failed to invest in their aging water and sewage systems. "Threats to the world’s freshwater resources are growing as populations grow, economic demands increase and institutions fail to respond. It is increasingly apparent that we are not properly managing water as a scarce resource," says Peter Gleick, president of the Pacific Institute, an environmental think tank in Oakland, Calif.

Jeff Czarniak, co-portfolio manager of investment firm TWF Management’s Water Fund, which is a predominantly long-short equity hedge fund, says that three fundamental factors make the water sector a great place to be for the next several decades. "First, there is the supply-demand imbalance of fresh water," he says. "Then there is the need for massive amounts of spending to repair and replace aging water infrastructure. And then finally, there is regulatory compliance. In the United States, for example, the Environmental Protection Agency is continually casting increasingly strict water quality standards, and water utilities and water treatment operators must upgrade and improve their water treatment systems to meet these." Indeed, analysts report that the funding gap for the country’s water infrastructure, some 700,000 miles of pipe systems, is estimated to be $600 billion—$250 billion for drinking water and $350 billion for wastewater. Moreover, at current renewal rates, governments would need an estimated 900 years to replace that infrastructure.

Hedge funds and mutual funds that invest in the global water industry are popping up like weeds.

Taking exposure to companies in positions to alleviate future fresh water scarcity problems appears promising, because the demand for their products and expertise will rise exponentially. Beyond infrastructure renewal, companies engaged in building and operating desalination plants, in supplying water cleaning and filtration systems, and in provisioning systems, such as metering equipment, for demand-side management should also benefit from the coming fresh water dearth.

Water Funds
While it may be easy to identify a large trend, profiting from it becomes a bit more difficult. In the case of water, however, many people are trying. Czarniak launched his firm’s water fund two years ago. It primarily invests in small-cap companies operating in the water sector, and also takes private equity stakes in certain firms. Investors in the fund can choose to retain or leave aside the private equity segment as part of their personal exposure.

Larger players, such as the Swiss firm Pictet, also offer products, including a clutch of water-related funds. Pictet’s Water-P Distr fund, for example, currently returns 26 percent annually. This fund invests in large, well-known names such as French company Veolia Environment, international services firm Suez and global conglomerate Nestlé. Most of the fund’s exposure (almost 40 percent) is to the water supply and treatment sector, followed by the water technology, environmental services and mineral water sectors. A large vehicle like Pictet’s illustrates one of the advantages of buying into a fund: The fee levels involved are much lower than those of a hedge fund. Pictet charges a 1.6 percent annual management fee. A hedge fund will typically charge a 2 percent management fee plus 20 percent of any upside the manager produces.

Of course, many large water funds may suffer from their strategy of taking exposure to huge, diverse, international firms, which may produce only a small amount of their overall profits from the water sector. "Be wary of funds that have very little trading volume and high expense ratios," warns Jason Cole, wealth advisor with Philadelphia-based Abacus Wealth Partners. Cole also counsels individuals to avoid funds investing in companies that have minimal water utility exposure.

According to Czarniak, investors derive real value in the water game by investing in smaller, more nimble companies operating in the water sector. "Water is a small-cap sector," he says, "It’s best to take advantage of those smaller-cap opportunities, rather than companies like Nestlé and General Electric."

Structured Notes
Many investment banks now sell structured notes designed to give investors exposure to the water industry. Structured notes are more popular in Europe and Asia than in the United States, though they are said to be attracting more investor interest in North America. Dutch bank ABN Amro has a product on the market called the Water Index Protected Plus Note. This is linked to a proprietary index it created in conjunction with Standard & Poor’s: the S&P Custom/ABN Amro Total Return Water Index. Only stocks that S&P’s analysts judge make at least 60 percent of their revenue from water can be included in the index. The fund also consists of large international players such as Veolia which, according to S&P, generates roughly 65 percent of its revenues from water. The notes offer exposure for six years and come with a guarantee that investors will get at least their initial investments back after that time.

Credit Suisse offers another structured note, a three-year product in its Global Water Basket, which offers exposure to 25 water-related stocks but with no capital guarantee. Products like this can be purchased through private banks.

Exchange-Traded Funds
A small number of water-focused exchange-traded funds are offered on the public markets. In May, for example, Claymore Advisors launched the Claymore S&P Global Water Index ETF on the American Stock Exchange. It tracks an index of 50 water-related companies, from water utilities to companies involved in well drilling and water testing. PowerShares offers its Water Resources Portfolio ETF, which is also listed on AMEX. It tracks the Palisades Global Water Index of global companies operating in the water sector.

John Ferry is an Edinburgh, Scotland–based financial journalist and a senior correspondent for Worth.