ETF Upgrading: Sweden, Malaysia in the Doghouse?

No Load Fund X, a 33-year old publication with an exceptional rating from The Hulbert Financial Digest, uses a concept called "Upgrading." In brief, upgrading involves the ranking of funds by relative performance in several risk categories; one sells the lowest ranked funds and "upgrades" to the highest ranked funds.

In the May 2008 edition of No Load Fund X, two international funds were left hung out to dry. From the "Most Speculative Stock Fund" list, the iShares MSCI Malaysia Fund (EWM) finished near the bottom. And from the "Speculative Stock Fund" list, the iShares MSCI Sweden Fund (EWD) found itself in last place.

In the Fund X world, you would sell these funds immediately. You might then choose to upgrade to more recent champs like Brazil (EWZ) or invest in broader exchange-traded baskets like Vanguard's Emerging Market Fund (VWO).

The question, however, is whether or not these single-country ETFs are really so bad. For example, EWD fell hard from its midsummer peak in 2007, losing 33% of its value. That was far worse than the 21% drop for the iShares Europe 350 (IEV). (This drop goes a long way to explaining why Sweden ranked so poorly in the No Load Fund X rankings.)

Yet technical and fundamental analysts might look at that huge fall from grace as a buying opportunity. After all, much of the excess drop was due to poor performance in telecom giant Ericsson (ERIC). And many have been looking at Ericsson's low P/E and high ROE (return on equity) as a value play.

There's more. EWD boasts a collective P/E of approx 12. It has climbed roughly 26% off its February lows. And, as I type, EWD is likely to break through its 200-day moving average. (Click chart to enlarge.)

On the other hand, it's hard to paint an equally rosy picture about Malaysia. Whereas the economic scenery had looked so splendid prior to March 2008, an unforeseen political disruption occurred when the ruling party lost its election and the prime minister refused to step down. EWM promptly dropped 10% on Monday, March 11, and has had difficulty finding traction ever since.

Personally, I find "Upgrading" a perfectly legitimate technique. It's unemotional and systematic. What's more, it has a long-term track record for capturing momentum.

Yet a portfolio that is constructed on relative strength rankings alone may take on questionable levels of risk. More importantly, long-term value opportunities might be missed.

Disclosure: The author is the president of Pacific Park Financial, Inc., which may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

Comments

[Hutch451]

With regards to Malaysia, the ruling coalition did not "lose" the election, it simply failed to retain a 2/3 majority of parliament; thus the Prime Minister is not required by law to step down (although some in the coalition believe he should). Although outcome for the ruling coalition were worse than expected, these results are viewed by many (myself included) as a maturing of Malaysia as a democracy, as (among other things) it puts pressure on the ruling coalition to resolve issues of chronic cronyism and corruption--which should bode well for the markets in the future. The selloff was an over-reaction by mainly foreign investors who don't fully understand the situation here, and may be lumping Malaysia into the same group as Thailand or the Philippines politically. Malaysia has a much more stable political environment than other SEA nations. Malaysia has a strong commodity basis in its economy (although it is developing its value-added sector as well), a positive balance of payments, and the currency has been strengthening steadily over the past several months (the currency did not take a hit as a result of the recent election). Thus, one could argue that Malaysia is a buying opportunity as well. I am keeping my options open and powder dry in this regard.