The iShares Dow Jones U.S. Aerospace & Defense Index ETF In Focus (ITA, UTX, BA, LMT)

Eric Dutram: Thanks to technological innovations and growing commercial and military demand, the global aerospace and defense industry has held up nicely this year. However there are concerns that the biggest consumer of defense equipment, the U.S. government, might cut their defense spending in the near future, potentially derailing growth in this corner of the market going forward.

This trend is further spread out across the globe in a number of other key markets such as United Kingdom, France, Germany and Spain. However, the investors focus more on the trend in the U.S.– the dominant player in this market, with nearly half of total military spending in the world, easily outpacing the next five biggest spenders combined (read: Can The Defense ETFs Soar Despite Headwinds?).

The U.S. military is facing possible cuts of $500 billion over the next decade (2012-2021), including $55 billion for 2013, if the Congress fails to find ways to reduce $1.2 trillion of fiscal deficits before the end of December.

In this difficult scenario of tight budgets and cuts to big programs, acquisitions offer big defense companies a way out to bolster their financial positions. Strategic alliances among companies have also been on the rise. The defense operators at times join forces with each other, bring along their individual expertise on the table and work as a cohesive unit for big defense deals.

Additionally, big international orders will also add to the growth of the aerospace and defense companies especially when the U.S. government is taking proactive steps to trim the defense budget. Further, a number of new emerging markets as well as developed nations, such as India, China, Japan, the United Arab Emirates, Saudi Arabia, and Brazil are boosting defense spending. (read: Get True Emerging Market Exposure With These Three ETFs) Moreover, increasing awareness of cyber threats could open up new markets for the defense majors despite lower demand for big ticket items like jets and tanks.

Considering the broad issues and opportunities, many aerospace and defense companies are holding up steady and, hence, investors could benefit from these positive market trends. A look at some of the top ranked ETFs in the space, with a lower level of risk, could be a good idea (see more ETFs in the Zacks ETF Center).

About the Zacks ETF Rank

A look at top ranked Aerospace & Defense ETFs can be done by using the Zacks ETF Rank. This technique provides a recommendation for the ETF in the context of our outlook of the underlying industry, sector, style box, or asset class. Our proprietary methodology also takes into account the risk preferences of investors as well.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of five ranks within each risk bucket. Thus, Zacks Rank reflects the expected return of an ETF relative to other ETFs with a similar level of risk.

Using this strategy, we have found one ETF in the space that has a Zacks Rank # 1 (Strong Buy) with a ‘low risk’ tolerant level. The details are highlighted below:

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

Investors seeking exposure to the U.S. aerospace & defense market may find ITA an intriguing choice. Launched in May 2006, this fund has emerged as a strong winner in the entire aerospace and defense space, producing more than 39% in returns over the past three years. The fund seeks to replicate the price and yield of the Dow Jones U.S. Select Aerospace & Defense Index, before fees and expense.

With holdings of 35 stocks, the product consists of manufacturers, assemblers and distributors of aircraft and aircraft parts in the aerospace industry as well as producers of components and equipment for the defense industry, such as military aircraft, radar equipment and weapons (read: Defense ETF Investing 101).

The fund does an average job in spreading assets across individual securities, as it puts about 55.2% of the assets in the top 10 firms. United Technologies (NYSE:UTX), Boeing Co. (NYSE:BA) and Lockheed Martin (NYSE:LMT) make up for more than 22% of the combined share in the basket. While the product is tilted towards the large caps with about 45% of the exposure, mid and small caps take up the remaining portion of ITA. As a result, the fund tends to be less volatile than many other products in the space.

From a sector perspective, aerospace has been the top priority of the fund representing 54% of the total assets, followed by defense with a 46% share. The product so far has managed assets of $88.3 million and has a mixed style box including growth, value and blend securities with a lower portfolio turnover of 16.0%.

The fund trades in a small volume of roughly 7,000 shares per day, suggesting a wide bid/ask spread beyond the expense ratio of 0.47% per year. Despite its illiquid nature,  the product is often considered a high momentum (the change in the fund’s price over the past three months) ETF with value closer to 104, suggesting that it will continue to move higher relative to its counterparts (read:Do You Need a High Momentum ETF?).

The ETF has delivered impressive returns of about 7.2% year-to-date (as of October 10) and yields 1.30% annually. Thus the fund is a decent play on the space with a lower level of risk.

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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