The aerospace and defense sector found its largest base in the U.S. with a military budget fittingly impressive. Of late, investors may rightly be worried about the fate of the defense industry in the U.S. considering the sequestration and budget austerities that are looming on the industry as a whole. (Read: 3 Hot Sector ETFs for 2014)

Nevertheless, leading contactors have emerged relatively unscathed so far, thanks to foreign contracts as well as small regular defense contracts.

Growing commercial opportunities on the heels of an improving global economy, a pick-up in defense spending in certain other countries and technological innovations and acquisitions actually made up for the military budget cuts. Meanwhile, from the civilian side, the commercial aircraft fleet is also aging fast which is spurring many airliners to upgrade their fleet.

In this perspective, amongst the big names, The Boeing Co. (BA) remains prudent enough to not only maintain its foothold in the commercial space, but also remains proactive in the defense arena despite budget austerities. (Read: Follow Warren Buffett in 2014 with these Sector ETFs)

ETFs to Tap the Sector

The aerospace and defense sector has been performing well over the past three months, overcoming fears of government spending cuts and sequestration. Exchange traded funds (ETFs) like SPDR S&P Aerospace & Defense (XAR) and iShares US Aerospace and Defense (ITA) have provided returns of 57.18% and 53.40%, respectively, in the year-to-date time frame. Investors have been pouring money in these stocks and ETFs over the past few months and the sector has significantly outperformed the broader market this year.

Below, we highlight the ETFs in the aerospace and defense sector, which primarily have a U.S. bias. Investing in these funds in basket form greatly reduces the risk of investing in particular stocks. Moreover, if one is interested in playing a sector, ETFs have an edge because it comes in a packaged form that gives instant access to a specific sector, the Aerospace & Defense sector in this particular case. The aerospace and defense stocks have performed well in the first nine months of the year and the benefits of the same have trickled down to the defense ETFs (Read: Play a Surging Defense Industry with These 3 ETFs).

SPDR S&P Aerospace & Defense ETF (XAR)

This fund follows the S&P Aerospace & Defense Select Industry Index, focusing on the Aerospace and Defense sector of the S&P Total Market Index. The Index is one of 19 S&P Select Industry Indices, each designed to measure the performance of a narrow sub-industry or group of sub-industries as defined by the Global Industry Classification Standards.

With holdings of 34 stocks, the top spots are taken up by Spirit AeroSystems Holdings Inc. Class A., Alliant Techsystems Inc. and The Boeing Co. comprising 5.01%, 4.71% and 4.60%, respectively, of total net assets.

Launched in September 2011, this index has a 99.48% focus on U.S companies with the balance 0.52% on others.

The fund so far has managed assets of $33.7 million and has an annual dividend yield of 1.63%. The top 10 companies hold a 44.04% share of total net assets. The average daily volume is about 2,523 shares.

iShares U.S. Aerospace & Defense ETF (ITA)

ITA tracks the Dow Jones U.S. Aerospace & Defense Index, providing exposure to companies related to the Aerospace and Defense industry in the U.S. equity market. This index has a 99.86% focus on U.S companies with the balance 0.14% on others. The fund has an annual dividend yield of 1.61%.

The ETF launched in May 2006 presently has nearly $296.2 million in AUM and average daily volume of 38,217 shares a day. This fund holds 39 stocks and ITA is a concentrated choice with about 56.41% invested in the top 10 holdings.

Among individual holdings, the top stocks in the ETF include The Boeing Company, United Technologies Corp and Precision Castparts Corp. comprising 9.87%, 8.70% and 6.33%, respectively, of total net assets.

Aerospace & Defense Profile (PPA)

This ETF tracks the SPADE Defense Index, holding 51 securities in its basket. 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 index was launched in October 2005.

This index has a 99.84% focus on U.S companies with the balance 0.16% on others. The fund so far has managed assets of $89.3 million. The top 10 companies hold a 53.01% share of total net assets. The average daily volume is about 33,519 shares and the fund has an annual dividend yield of 1.19%.

In terms of holdings, The Boeing Company, Lockheed Martin Corp. and Honeywell International Inc. occupy the top three positions in the basket comprising 6.82%, 6.56% and 6.13%, respectively, of total net assets.

To Sum Up

The aerospace & defense sector has been a keystone of the U.S. economy for decades and has provided well paying jobs for a variety of skill levels. However, the sector’s position is now challenged by global competition, changes in technology, national and worldwide economic conditions, and global policies affecting defense, civilian and commercial aviation.

Sequestration still remains an overhang both in the civil and military sectors. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration. Recently, the House and Senate negotiators have reached a two-year budget agreement, mitigating about half the sequester cuts expected to gouge the defense budget in fiscal year 2014. Upon successful approval from both the House and Senate, any near-term government shutdown will be averted.

Nonetheless, undeterred by defense budget cuts, the big defense operators are expanding their operations through acquisitions. Moreover, in order to counter the domestic headwinds, these players are looking for growth from international orders and are busy restructuring their businesses. Also, they are keeping themselves abreast in the technological front with new products countering fresh competition.

To conclude, the sector definitely enjoyed a solid earnings season, technological progress, acquisition benefits and cost-cutting efforts from individual companies. But these positives are held in balance by defense budget austerities. This keeps us Neutral on the sector for the time being.

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