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TheStreet.com Ratings: Model ETF Portfolio

Rudy Martin

Our ratings model takes a cautious view of domestic stocks. While the market is still up over the 12 months ended Feb. 28, the momentum is slowing. February's losses erased all the gains made in January.

You can blame it on falling home prices. You can blame it on a former Federal Reserve chairman's media-magnified comments. Or you can blame it on speculation in either Chinese stocks or the Japanese yen. The results are the same. The U.S. stock market seems to be pausing but still retains some positive aspects.

Our theoretical $10,000 portfolio of 10 exchange-traded funds illustrates this. In the period from Feb. 6 through Feb. 28, the portfolio lost 2.65%, in line with the major large-cap benchmarks. During the same period, the Dow Jones Industrial Diamonds (DIA Quote) dropped 2.98%, while the S&P 500 SPDR (SPY Quote) (SPY) fell 2.73%.

Domestic utilities, European value and Pacific Ex-Japan held up the best amid February's selloff, while capital markets, REITs and emerging markets were hit the hardest.

The positive highlight of the month was the ML Utilities HLDR(UTH Quote). This ETF benefited from the news that private-equity investors were lining up for a $45 billion buyout of a core holding, Texas Utilities (TXU Quote). On Feb. 26, the day the deal was announced, the fund gained 3%. It finished the period up 2.85%.

Before we discuss our portfolio changes, a note on the chart above: We have relabeled the columns to make it clearer that our monthly performance numbers are based on total return, which includes both price appreciation and dividends. As we have said in the past, the monthly aggregate total return is based on the amount allocated to each investment. For this purpose we use 10 funds to cover a broad universe of investment options and markets allocating approximately $1,000 to each based on the actual market price and without using fractional share positions.

Because we rebalance the theoretical portfolio back to $10,000 each month, multi-period returns may be understated. In effect, we cap the gains on our winning picks, although, to be fair, we also cap losses on our losing positions. But the point is that a successful investment strategy takes advantage of compounding returns -- this is key to building wealth over longer time horizons.

So how are we readjusting? We're moving money out of financials and into materials, large-caps and dividend plays.

Here's a recap of our ongoing ETF investment themes:

Look abroad for real growth:

• Europe is a beneficiary of the flight to quality. With the dollar on the decline again, European large-caps promise to deliver gains that beat the DJIA. Our selection in this area remains the iShares MSCI EAFE Value (EFV Quote) ETF. It sells at 15.8 times earnings vs. 19.3 times for the more popular iShares MSCI EAFE (EFA Quote). The iShares MSCI EAFE Value provides global exposure with a geographic portfolio distribution that is 50% Europe, 25% Japan and 25% other.
• Emerging markets are still core holdings. Investing in Brazil, Russia, India and China means you will see occasional overreactions to news and corrections. Our choice among these is still Vanguard Emerging Markets ETF (VWO Quote), which lost 4.4% during our February holding period and 8.58% last week. Investing in emerging markets is risky, but the current downturn looks to be more of a correction than a new bear market.
• Invest in China indirectly. Our portfolio pick, the iShares MSCI Ex-Japan (EPP Quote) has two-thirds of assets in Australia, 20% in Hong Kong and the rest in Singapore and other Pacific countries. The main sector exposure is primarily banking and real estate, which together account for almost 40% of the portfolio. This ETF also provides a 4.25% yield, for long-term investors looking to add income to their overall portfolios. But note that this distribution comes at year-end, not on a quarterly basis, as is more common with ETFs based on U.S. stock indexes. The iShares MSCI Ex-Japan held up relatively well in February, losing only 1.1%.

The U.S. economy is still growing:

Let's not forget that we still have positive economic growth in the U.S. The chart below illustrates the trends in 12-month moving returns for some of the leading sector funds. Two ETF groups that ranked well in our model were sectors that tend to do well late in the economic cycle, such as materials and utilities. These sectors were up 18.17% and 21.15% over the 12 months ended March 2, respectively, on the basis of U.S. SPDR benchmarks for those two sectors. The chart also points to the weakness in technology stocks, which were up just 3.10% over the same period a year ago.

Materials Sector Holding Up Well

Click here for larger image.