With Sequester Ahead, Are Defense ETFs in Trouble?
Zacks Equity Research
The U.S. is home to the world’s largest aerospace and defense market and also has the world’s largest military budget. The industry is mainly dependent on U.S. government contracts which also imply that defense spending by the government largely decides the outlook for the industry, which isn’t good news given the latest talk of budget cuts (Defense ETF Investing 101).
Currently, U.S. defense spending is negatively impacted by the Budget Control Act of 2011. On Jan 1, 2013, the House partially averted the fiscal cliff and delayed spending cuts or sequestration by two months.
The two-month breather is finally coming to an end and the U.S. defense industry has little hope of averting the consequences. The sequester is expected to kick in on Mar 1, 2013 and could greatly impact the defense industry.
The sequestration cuts mandated by the Aug 2011 debt-limit deal includes a $500 billion cut in spending (over 10 years) on top of the $487 billion which has already being cut by the Obama administration from defense spending over the same time period (Any hope for Aerospace and Defense Industry ETFs in 2013?).
Although the immediate impact of the sequester was postponed for some time yet it looms large on the defense industry. Along with the Pentagon cut of $500 billion spread over 10 years, sequestration is also inclusive of domestic discretionary spending cut of the same amount.
Recently back President Obama made an effort to rescue the defense industry from the adverse effects of sequestration. His plan included an arrangement that would lead to both tax increases and spending cuts. If enforced it would have led to $21 billion less in defense spending cut for this fiscal year and roughly $250 billion less through fiscal 2022.
Impact of Sequester on U.S. Military
The sequester would result in the U.S. military having to cut its work force, and restrain training and maintenance of existing forces. Many big budget and high tech defense programs look to be on the chopping block as well, so the cuts could stretch across the military.
Impact of Sequester on Defense Companies
The cuts could also have an adverse effect on the companies within the defense industry. The bottom line of many companies will be negatively affected. Ultimately the prices of many defense stocks will tend to fall.
The fear of the spending cut can already be seen in defense manufacturing giant Lockheed Martin (LMT). The company reported a decline in net profit for the fourth quarter of 2012. Lockheed Martin was compelled to slow the pace of its production and also lay off hundreds of employees when the U.S. government cut the number of F-35 jet fighters it plans to buy (Can The Defense ETFs Soar Despite Headwinds?).
It should be noted that though the sequestration will test the large defense contractors sourly, the smaller companies are the ones to be the worst hit. Smaller companies that frame the industry's supply chain would be severely impacted, as they are less diversified than many of their large cap counterparts.
Given this backdrop, investors may opt to avoid investing in ETFs that provide exposure to the U.S. defense companies. Below we have highlighted a few of the ETFs that track the U.S. defense companies and could be in for a wild ride ahead:
iShares Dow Jones U.S. Aerospace & Defense Index Fund (ITA)
With holdings of 33 stocks, ITA 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 (Zacks #1 Ranked Aerospace & Defense ETF in Focus).
The fund puts about 53.96% of its focus on the top 10 firms. United Technologies, Boeing Co. and Precision Castparts make up more than 22% of the combined share in the basket.
From a sector perspective, 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 $81.5 million.
The fund trades in a small volume of roughly 3,400 shares per day, suggesting a wide bid/ask spread, increasing total costs beyond the expense ratio of 0.46% per year.
PPA seeks to invest its $45.8 million asset base in 48 stocks, more than what ITA holds. Although the fund appears to be heavily invested in the top 10 holdings, the percentage holding in the top 10 is still less than ITA. The fund invests 51.9% of its assets in the top 10 holdings.
United Technologies Corp, Honeywell International Inc. and The Boeing Company occupy the top three positions in the fund (Try Value Investing with These Large Cap ETFs).
The fund charges an expense ratio of 66 basis points and has returned 17.85% to investors over a period of one year.
Launched in Sep 2011, the SPDR S&P Aerospace & Defense ETF is the most recent addition in the aerospace & defense ETF world.
The fund seeks to invest its total asset base of $13.3 million in 34 stocks. However, the fund appears to be somewhat concentrated in the top 10 holdings as it invests 47.2% of its assets in the top 10 companies.
Among individual holdings, Textron Inc. (5.13%), Triumph Group Inc New (4.96%) and Transdigm Group Inc (4.85%) occupy the top 3 positions in the fund. Over a period of one year, the fund has delivered a return of 6% and charges investors 35 basis points in the form of fees for investment made in it, the lowest among the three ETFs in the space.
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