The Case For Defense ETFs
December 29, 2009
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Defense stocks are often overlooked as too granular for all but the most tactical asset allocators. A subsector of the economy, they are a far cry from any broad-based take on an investment strategy.
But defense is attracting increased attention from investors looking for strong and somewhat noncorrelated returns.
The attractions are many.
For starters, defense spending represents nearly 5 percent of U.S. GDP, according to the latest Pentagon figures, and that figure is unlikely to shrink anytime soon. It’s a substantial force in our daily lives that is underrepresented in the major indexes.
More importantly, this spending has translated into strong returns for investors. A broad index of defense stocks has consistently outperformed the S&P 500 Index for the last nine consecutive years.
Finally, because defense budgets are driven by government spending, there is a natural countercyclical benefit to investors. Aerospace and defense budgets have seen steady increases for decades, with only minor interruptions. As the market anticipates further growth over time, allocating to defense is as much a play on the government contractor market as it is on the defense sector itself.
Historical Performance: DXS Vs. S&P 500
Source: Yahoo Finance Data
How To Gain Exposure
In the ETF space, two ETFs provide exposure to aerospace and defense. Though they play in the same playground, they choose slightly different toys. They are the PowerShares Aerospace & Defense Portfolio (NYSEArca: PPA) and iShares Dow Jones U.S. Aerospace & Defense Index Fund (NYSEArca: ITA).
PPA holds a more diversified basket of securities than ITA—58 vs. 32—but the bigger difference lies in how they choose those components. While PPA takes an inclusive approach, capturing all firms that play a significant role in the defense industry, ITA focuses on pure plays and eschews the bigger conglomerates.
Consider each fund’s top 10 holdings: PPA’s inclusion of Honeywell exemplifies this issue. Honeywell is a company PPA considers of vital importance to the defense segment. Honeywell ranked 15 in the Defense News Top 100 for 2008 with more than $5 billion in revenues coming from defense alone.
But the company has more than $30 billion in annual revenues, so while it is a major player in the defense industry, it is not just a defense firm.
ITA uses a “pure-play screen” to isolate companies that derive the bulk of their revenues from defense operations. As a result, it sees Honeywell as too diversified to fit into any of the rigid categories its benchmark Dow Jones Index employs.
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