How To Play A Surging Defense Industry With ETFs

defense stocksThe defense sector has held up this year, overcoming the fears of sequestration and spending cuts to big-ticket programs that are expected to hurt the performances of the industry behemoths. In fact, the sector has easily outpaced the broad S&P 500 index over the trailing three months by wide margins.

The sequester, which was put into effect in March 2013, has resulted in broad budget cuts. Generally, spending on nearly every U.S. defense budget item has been lowered by 10%. The impact of budget sequestration proved less-than-feared, thereby leading to a rally in the defense and aerospace securities across the board (read: 2 Sector ETFs Surging This Earnings Season).

This is largely thanks to technological innovation, big contracts, international orders, acquisitions, and growing commercial demand. Further, a pickup in defense spending in a number of new emerging markets as well as developed nations such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil have opened doors to the U.S. aerospace and defense companies.

Strategic alliances with other foreign nations often entail the U.S. to share its military technology and supply weapons to its allies, which in turn boost the sector’s revenues.

The bullish trend in the aerospace & defense space is expected to continue to close out the year on the back of solid earnings by top players. The industry giants – Boeing (BA), Lockheed Martin (LMT), United Technologies (UTX), Northrop Grumman (NOC), Honeywell International (HON) and General Dynamics (GD)  –reported better-than-expected results this earnings season.

Further, earnings estimate revision ratios for these firms have been among the highest in the S&P 500 for both 2013 and 2014, suggesting a bright outlook for the space. The rise in commercial orders will also help to counter government issues should those start to plague the sector.

How to Play

Considering broad opportunities as well as remarkable earnings by defense giants, investors seeking to play the defense market could consider the following ETFs for broad exposure to the space:

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

This fund follows the Dow Jones U.S. Select Aerospace & Defense Index, giving investors exposure to the broad aerospace and defense industry. With holdings of 35 stocks, the fund allocates higher weights to the top two firms – UTX and BA – at 9.46% and 8.33%, respectively. Other securities hold less than 6.12% of total assets each.

From a sector perspective, aerospace has been the top priority representing 55.5% of ITA while defense takes the remainder of the basket. The fund has accumulated $115.4 million in AUM while charging 46 bps in fees a year. Volume is light, probably increasing the total cost for the fund.

The ETF is up over 11.5% in the trailing three month period and over 28.4% so far this year. The fund currently has a Zacks ETF Rank of 1 or ‘Strong Buy’ with ‘Low’ risk outlook (read:3 Hot Sector ETFs Surging to #1 Ranks). This suggests that the product is expected to outperform its peers over the next one year.

PowerShares Aerospace & Defense Portfolio (PPA)

This ETF tracks the SPADE Defense Index, holding 48 securities in its basket. The fund so far has managed assets of $61.3 million while average daily volume is light, suggesting additional cost in the form of wide bid/ask spread beyond the expense ratio of 0.66% per year.

In terms of holdings, UTX, LMT and HON occupy the top three positions in the basket with at least 6% share each. Though the aerospace and defense sector takes nearly 81% share, information technology and materials also have a decent exposure in the basket (read: Time for This Top Ranked Defense ETF?).

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