Wars and global conflicts in the Middle East and Ukraine have increased defense spending and heightened security concerns, which in turn affect the defense industry and can potentially boost the performance of defense ETFs.
Investors need to know, however, that a defense ETF can provide more than just growth potential from increasing defense spending. Learn the benefits and risks of investing in defense and aerospace ETFs and see the top defense sector funds.
What Is a Defense ETF?
A defense ETF is an exchange-traded fund that invests in companies operating within the defense and aerospace sector. These funds typically track a benchmark, such as the Dow Jones U.S. Select Aerospace & Defense Index, which includes stocks of companies involved in the production of military equipment, technology, aerospace and related products and services, such as cybersecurity.
Many of the companies within the defense and aerospace sector have substantial contracts with government entities, particularly the U.S. Department of Defense.
Why Invest in Defense and Aerospace ETFs?
Investing in defense and aerospace ETFs can be a strategic choice for investors who are looking to achieve specific investment objectives, such as portfolio diversification, technological advancements in cybersecurity, growth in government defense contracts and potential for income.
Here are some reasons why investors might consider investing in defense and aerospace ETFs:
Portfolio diversification: Defense and aerospace ETFs provide exposure to a sector that may not be correlated with other segments of the market. Diversifying your investment portfolio across different sectors can help spread risk.
Technological advancements: The defense sector often involves cutting-edge technology and innovation. Investing in defense and aerospace ETFs allows investors to participate in advancements in technology, which can have applications in various industries beyond defense.
Government contracts: Many companies in the defense sector have long-term contracts with government entities, particularly the U.S. Department of Defense. The contracts can provide a steady stream of income and revenue stability for these companies.
Stability and resilience: The defense sector tends to be relatively stable because it is less influenced by economic cycles than other sectors. Governments often allocate a portion of their budgets to defense, which can provide a reliable source of revenue for defense companies, even during economic downturns.
Global security: Geopolitical events and security concerns can influence the defense industry. Increased defense spending, changes in international relations and global security concerns can affect the performance of defense and aerospace companies.
Potential for dividend income: Some companies in the defense and aerospace sector pay dividends. Investing in defense ETFs may provide investors with opportunities for dividend income.
Long-term investment: The nature of government contracts and the long development cycles for defense projects often make the defense sector a long-term investment. Investors looking for stability and long-term growth may find this sector appealing.
National defense: Investing in the defense and aerospace sector can be seen as supporting national defense efforts, which may be appealing to some investors.
How Wars and Global Conflicts Impact Defense Stocks and ETFs
Wars and other global conflicts have a significant impact on defense stocks. Historically, defense stocks tend to rise in response to geopolitical tensions and conflicts. That is because increased tensions and conflicts lead to higher demand for defense products and services.
For example, the stock prices of major defense contractors such as Lockheed Martin (LMT), Northrop Grumman Corp. (NOC) and RTX Corp. (RTX), which includes Raytheon Intelligence & Space and Raytheon Missiles & Defense, all rose significantly following the onset of the Israeli-Hama war in 2023 and Russia's invasion of Ukraine in 2022. That was because of the expectation that the conflicts would lead to increased demand for defense products and services.
For reference, the top three largest defense ETFs gained an average of about 3.0% in the month of October 2023, when the Israeli-Hamas war started. The 10-year returns averaged about 11.0%.
However, the impact of global conflicts and wars on defense stocks is not always straightforward. In some cases, conflicts can actually lead to a decline in defense stocks if investors perceive that the conflict is not likely to lead to a significant increase in defense spending.
Overall, the impact of global conflicts and wars on defense stocks is complex and depends on a variety of factors, including the severity of the conflict, the perceived threat to national security and the overall economic outlook.
Data as of October 1, 2024. Past performance is no guarantee of future results.
The Risks of Investing in Defense ETFs
Investing in aerospace and defense ETFs can offer diversification and potential benefits, but like with any investment, it carries certain risks and considerations. Here are some of the risks associated with investing in defense ETFs:
Government policy and budget risk: The defense industry is heavily influenced by government policy and defense budgets. Changes in government priorities, defense spending levels and budget cuts can significantly affect the performance of defense companies. Political decisions can lead to fluctuations in revenue for defense contractors.
Market cyclical trends: While the defense sector is generally less cyclical than other industries, it is not immune to economic downturns. Market conditions and economic factors can affect the demand for defense and aerospace products and services.
Competition: The defense and aerospace industry is highly competitive, with numerous companies vying for government contracts and international markets. Competition can affect profit margins and market share.
Technology risk: The defense sector involves rapid technological advancements. Companies must continually innovate to remain competitive. Technological changes can render existing products obsolete, and delays or problems in development can affect financial performance.
Regulatory and compliance risks: Defense contractors are subject to strict regulations, and noncompliance can lead to legal issues and financial penalties. Changes in regulations can also affect the industry's operational and financial landscape.
Defense and Aerospace ETFs: Bottom Line
It's important to recognize that the performance of defense ETFs can be influenced by government defense spending, international relations and economic conditions. Investors interested in defense ETFs should conduct thorough research, understand the holdings and expenses associated with the ETF and consider how the fund aligns with their investment objectives and risk tolerance.
Additionally, investors should consider the expenses associated with ETFs and carefully research the specific holdings and strategies of the funds they are considering.
