PPA Invesco Aerospace & Defense ETF

The global aerospace and defense industry is showing remarkable improvements this year thanks to rising demand for commercial and military activities, and technological innovations. This comes despite the biggest consumer of defense equipment, the U.S. government, possibly taking an axe to their broad spending in the near future, potentially derailing growth in this corner of the market going forward.

This trend is further continued across the globe in a number of other key markets. However, the issue always flows back to the U.S. as America accounts for 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?).

Defense Budget Cuts: Reason for Worry?

Due to this trend, the Department of Defense (DoD) has proposed a base budget of $525.4 billion for fiscal 2013 with $88.5 billion for overseas operations spending, primarily in Afghanistan. The proposed budget is less than the $531 billion base budget and $115 billion for overseas operations approved for fiscal 2012.

Additionally, the U.S. military is facing budget cuts of $500 billion over the next decade (2012-2021), including $55 billion for 2013, if Congress fails to find proper ways to reduce $1.2 trillion of fiscal deficits before the end of December. So investors and market participants could see a huge drop off in spending in the coming years, especially if forays into other nations are curtailed and troops are removed from the broader Middle East and South Asia regions (read: Three ETFs For An Iranian Crisis).

The spending cuts will certainly impact big contractors, as the lion’s share of their revenues comes from domestic defense spending. The cutbacks would not only harm major contractors, but will likely trickle down into the job market as well with a great deal of layoffs across the nation.  

However, these cuts are by no means guaranteed, especially given the numerous geopolitical risks across the globe. Additionally, 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.

Some of these new markets could help ease the pain for major defense contractors and assist them in producing at a high level despite a decline in spending from the top market for defense goods in the world (read: Time for a Merger Arbitrage ETF?).

Further, cyber security offers a new window of opportunity with both government and private players seeking ways to safeguard against online attacks. 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.

How to Play Defense Stocks

Investors seeking to play the defense market but are still worried about budget cuts, may be better served with an ETF approach. Currently there are three ETFs that target the defense and aerospace market, each of which we have highlighted in greater detail below: (See more ETFs in the Zacks ETF Center):

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

Investors seeking exposure to the U.S. Aerospace & Defense market may find ITA an intriguing choice. 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 33 stocks, the product consists of manufacturers, assemblers and distributors of aircraft and aircraft parts in the aerospace as well as producers of components and equipment for the defense industry, such as military aircraft, radar equipment and weapons.

The fund does just an average job in spreading assets across individual securities, as it puts about 59% of focus on the top 10 firms. United Technologies (UTX), Boeing Co. (BA) and Lockheed Martin (LMT) make up more than 24% of the combined share in the basket. While the product is tilted towards the large caps with more than 50% of the exposure, mid and small caps take up the remaining portion of ITA (read: Try Value Investing with These Large Cap ETFs).

From a sector look, aerospace has been the top priority of the fund representing 55% of the total assets, followed by defense with a 45% share. The product so far has managed assets of $89.8 million and was launched on May 2006.

The fund trades in a small volume of roughly 7,000 shares per day, suggesting wide bid/ask spread beyond the expense ratio of 0.47% per year. Despite its illiquid nature, the fund has delivered impressive returns of about 6% year-to-date (as of August 31) and yields 0.94% annually. Such returns are much more than the total expense, making it a decent play on the space.

PowerShares Aerospace & Defense Portfolio (PPA)

Launched in October 2005, PPA matches the performance of the SPADE Defense Index. The stocks considered in the fund are the companies engaged in the development, manufacturing, operations and support of U.S. defense, homeland security and aerospace operations.

The products seeks to invest about 50% of its assets in the top 10 holdings, with Honeywell International (HON), United Technologies and Boeing Co taking up the top three spots in the basket. This allocation is arguably better than ITA and the fund holds a total of 50 securities in the portfolio, which has a nice mix of different asset classes. Large caps accounted for 45% share while mid and small caps accounted for 35% and 20%, respectively.

Unlike ITA, the product does not only include securities from the aerospace and defense sectors, but also contains technology and material companies, with 17% and 4% share, respectively (read: Three ETFs To Play The Tech IPO Boom).

With AUM of $47.9 million, PPA has been the best performer in the aerospace and defense sector so far in the year, returning more than 9% (as of August 31) and yielding 1.14% annually. Although the returns are encouraging, the fund charges 66 bps in fees per year from investors, which is higher than its iShares counterpart. The fund is more liquid than ITA, trading in volumes of 10,000 shares per day on average.

SPDR S&P Aerospace & Defense ETF (SAR)

This fund is the new entrant into the aerospace and defense space, making its debut in September 2011. It tracks the S&P Aerospace & Defense Select Industry Index, a subset of S&P Total Stock Market Index.

Like ITA, the product invests all of its assets in the aerospace and defense industry with large concentration (45%) in the top 10 holdings. Northrop Grumman Corp (NOC), Spirit Aerosystems Holdings (SPR) and Lockheed Martin occupy the top positions in the basket with a combined 14% share.

Nevertheless, the product has a nice mix of portfolio with 36 securities. While large caps comprise about 40% of the assets, mid and small caps account for 35% and 25%, respectively.

This ETF is the low cost choice in the aerospace and defense space, charging only 35 bps in annual fees from investors. However, the product has a relatively higher bid/ask spread thanks to the paltry average daily volume of 2,000 shares. With total assets of $14.9 million, the fund has delivered an excellent return of 7% so far in the year and yields 0.55% of dividend per annum (read: The Five Best ETFs over the Past Five Years).

Provided below is the summary of the three ETFs:

 

Fund Name	Inception Date	Issuer	AUM (in millions)	No. of Holdings	% of Assets In Top 10 Holdings	Expense Ratio	Distribution Yield	YTD Return (as of August 31, 2012)
ITA	01-May-06	iShares	$89.75	33	58.73%	0.47%	0.94%	5.84%
PPA	26-Oct-05	PowerShares	$47.95	50	50.44%	0.66%	1.14%	9.17%
XAR	29-Sep-11	State Street	$14.86	34	44.84%	0.35%	0.55%	6.92%

 Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>

 
BOEING CO (BA): Free Stock Analysis Report
 
ISHARS-DJ AEROS (ITA): ETF Research Reports
 
PWRSH-AERO&DEF (PPA): ETF Research Reports
 
SARATOGA INVEST (SAR): Free Stock Analysis Report
 
UTD TECHS CORP (UTX): Free Stock Analysis Report
 
To read this article on Zacks.com click here.
 
Zacks Investment Research
 
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report