Can The Defense ETFs Soar Despite Headwinds? (ITA, PPA, XAR, BA, UTX, TDG, LLL, HON, PCP)

Eric Dutram: The U.S. is the world’s largest aerospace and defense market. The growth of this sector is heavily tied to the spending outlook of the government. This year, Congress has passed the defense authorization bill for $662 billion which mainly comprises $529.6 billion for core spending. The bill also includes a provision of $115.5 billion for the wars in Afghanistan and Iraq and $16.9 billion for the Department of Energy’s defense programs.

The U.S. alone accounts for 40% of total global spending on defense. But with the U.S. government deciding to pare the defense budget, and with drawdown of troops from Afghanistan and Iraq, major defense companies now have to scout for more business from overseas destinations instead (read Three ETFs For An Iranian Crisis).

In this difficult scenario of tight budgets and cuts to big programs, acquisitions offer big defense companies with strong financials to bolster their positions. The U.S. Defense department also supports mergers among the defense companies except for the top group of suppliers acquiring each other.

Strategic alliances among companies have been on the rise. The defense operators at times join forces with each other, bring along their individual expertise in the table and work as a cohesive unit for big defense deals.

Additionally, big international orders will also add to the growth of the defense companies especially when the U.S. government is taking proactive steps to trim the defense budget. One of the noticeable international orders in the recent past has been Japan Ministry of Defense’s choosing Lockheed’s F-35 Lightning II as Japan Air Self Defense Force’s next generation fighter aircraft.

The Boeing Company (NYSE:BA) received an order from the Kingdom of Saudi Arabia for 84 new F-15 fighter aircrafts and to upgrade 70 existing F-15s. Besides, Boeing also received orders for 70 new AH-64 Apache strike helicopters and 36 AH-6i helicopters, plus support and training. This slew of orders would boost Boeing’s top line by $24 billion.

At the macro level, a gradual shift in defense spending patterns can be discerned. In response to asymmetric terrorist threats, the emphasis appears to have shifted to high-tech intelligence equipment, replacing demand for conventional big guns and heavy armor. The major industry players have, in response, resorted to bolt-on acquisitions to plug gaps in their product offerings.

Continuous technology upgrades are imperative, in specialized niches like aerospace and defense, to meet the complex and varied needs of customers. Among the state-of-the-art products, the latest radar and telecommunication systems, new ballistic missiles, unmanned warplanes, development of fighter jets, and sophisticated surveillance equipment have been most in demand worldwide (read Three Great Tech ETFs That Avoid Apple).

Also, Asian countries are keen on increasing their defense budget although not in the same capacity as U.S. and European countries. China has been focused on strengthening its defense capability and has accordingly bolstered its budget. India also plans to spend $80 billion in a span of five years in order to build up their defense force as well.

However, the global downturn has certainly impacted the Aerospace and Defense industry as many countries were compelled to cut their defense expenses. Instead of defense spending, many of the biggest spenders are gradually lowering their defense budgets and concentrating on other avenues to fix their ailing economy (see more on ETFs at the Zacks ETF Center).

A similar situation is happening at home at well as speculation is beginning to build over a plan to reduce the defense budget by $100 billion over the next five years. These cutbacks will impact the big contractors as the lion’s share of their revenues comes from domestic defense spending.

Meanwhile, the United Kingdom is likewise planning to slash its defense budget by 20% while Italy, thanks to its own budget woes, has decided to follow a similar path. There is also pressure on France, Germany and Spain to review and trim their defense spending for similar reasons as well.

Additionally, Obama’s decision to delay the funding of many projects led to the termination of many projects. Accordingly, after assessing the current and future market potential, Boeing decided to shut down its Boeing Defense, Space & Security facility in Wichita by the end of 2013.

Improvement in the exchange-traded fund industry has showed the path for the building of products inclined towards the aerospace & defense industry. Investors seeking to play on this slice of the market should look for ETFs like XAR, PPA and ITA.

If the companies continue to book new orders, these funds could get a nice boost. However, if recent market turbulence causes governments to cut back their defense budgets further, then these funds could be in trouble.

Dow Jones U.S. Aerospace & Defense Index Fund (NYSEARCA:ITA)

The iShares Dow Jones U.S. Aerospace & Defense Index Fund is the most popular ETF in the aerospace and defense industry and is linked to the Dow Jones U.S. Select Aerospace & Defense Index. The fund has the highest AUM in the aerospace and defense ETF space of $66.95 million.

The fund seeks to invest in 34 holdings giving the product a 58.8% concentration in the top ten securities. United Technologies Corp. (NYSE:UTX), The Boeing Company (NYSE:BA) and Precision Castparts Corp. (NYSE:PCP) occupy the top three positions with 9.4%, 8.71%, and 6.40% of assets invested, respectively. Among the sectors, Aerospace has been the top priority of the fund representing a 58.46% of the total assets.

Defense has been the second preference with 41.43% of investment. The fund has delivered a return of 5.65% over a period of one year and charges an expense ratio of 47 basis points from investors (read Mid Cap ETF Investing 101).

Power Shares Aerospace & Defense Portfolio (NYSEARCA:PPA)

Another popular ETF targeting the aerospace and defense industry is the Power Shares Aerospace & Defense Portfolio which is linked to the SPADE Defense Index. The Index is designed to identify a group of companies involved in the development, manufacturing, operations and support of U.S. defense, homeland security and aerospace operations.

The fund seeks to invest its $20.02 million asset base in 51 stocks, more than what ITA holds. Although the fund appears to be heavily invested in the top 10 holdings; the percentage holding in top 10 is still less than ITA. The fund invests 49.79% of its assets in the top 10 holdings.

Unlike ITA, The Boeing Company (NYSE:BA) occupies the top position in the fund while United Technologies Corp. (NYSE:UTX) is in third. The second position has been occupied by Honeywell International Inc. (NYSE:HON). Among sectors, the fund concentrates more on industrials with 80.32% of investment made in it.

In spite of the attractive holding pattern, the fund delivered a negative return of 0.06% over a period of one year compared to the positive return delivered by ITA. The fund is also more expensive than ITA charging 66 basis points per year.

SPDR S&P Aerospace & Defense ETF (NYSEARCA:XAR)

Launched in September 2011, The SPDR S&P Aerospace & Defense ETF is the most recent addition in the aerospace & defense ETF world. It seeks to replicate as closely as possible, before expenses, the total return performance of the S&P Aerospace & Defense Select Industry Index, a benchmark that tracks a group of companies involved in the development, manufacturing, operations and support of U.S. defense, homeland security, and aerospace operations (see the Comprehensive Guide to Utility ETF Investing).

The fund seeks to invest its total asset base of $15.35 million in 35 stocks. However, the fund appears to be somewhat concentrated in the top 10 holdings as it invests 45.19% of its assets in the top 10 companies. Among the sectors, the fund appears to be more concentrated in industrials with 93.19% of the investment going to the space.

The rest has been assigned to Technology and Consumer cyclical.TransDigm Group Incorporated (NYSE:TDG), Hexcel Corp and L-3 Communications Holdings Inc. (NYSE:LLL) occupy the top 3 positions in the fund. Since inception, the fund has delivered a return of 23.58% and charges investors 35 basis points in the form of fees for investment made in it, the lowest among the three ETFs in the space.

Overall Outlook for Defense ETFs

The U.S. is the leader in global defense spending. The country is not only a major superpower, but it has strategic alliances in place with other foreign nations with major military strengths and geopolitical concerns as well. The country sometimes shares its military technology and supplies sophisticated weapons to its allies.

These activities in turn boost the revenue of the defense operators.  The industry has been performing well at times of global recession compared to other industries, so investors seeking better diversification should consider including ETFs targeting the aerospace & defense industry in the portfolio.

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Written By Eric Dutram From Zacks Investment Research

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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