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While there are great concerns about the Obama administration’s views towards military spending, many external threats seem unlikely to dissipate in the coming decade, meaning that the aerospace & defense sector may be one of the most stable American industries. Since military goods are among the few products that are still made primarily on American soil, many are looking to this sector to help American industry survive the current downturn. Moreover, U.S. allies such as Japan are looking to upgrade their defenses, a trend from which U.S. defense companies could benefit.

There are several reasons to be bullish on the aerospace & defense sector. Boeing (BA) still has years of backlog for its 787 Dreamliner (despite the numerous delays). United Technologies (UTX) has seen strong demand for its engines and aircraft business lines. Should the dollar continue to decline, these products will become more in demand and become more affordable to businesses in emerging markets across the globe.

For investors looking to make a play on the Aerospace & Defense sector, there are two funds offering targeted exposure: the PowerShares Aerospace and Defense ETF (PPA) and iShares Dow Jones US Aerospace and Defense Index Fund (ITA). In fact, both of the funds have outperformed SPY over the past 52 weeks, an indication that the defense industry still has a fighting chance of bringing gains to your portfolio. While these ETFs are similar in many ways, they also have their fair share of differences.

Indexes

The PowerShares fund follows the SPADE Defense Index, a benchmark that tracks a group of companies involved in the development, manufacturing, operations and support of U.S. defense, homeland security, and aerospace operations. The modified market-cap portfolio is rebalanced quarterly and reconstituted annually.

The iShares fund tracks the Dow Jones U.S. Select Aerospace & Defense index. The index measures the performance of the aerospace and defense sector of the U.S. equity market. The Aerospace companies include manufacturers, assemblers and distributors of aircraft and aircraft parts, while the defense sector includes producers of components and equipment for the defense industry, such as military aircraft, radar equipment, and weapons. The fund uses a representative sampling strategy to track the index.

Holdings

While the funds have similar holdings, there are a few key differences. ITA has the vast majority of its holdings in industrial materials firms (nearly 95%) while PPA is more diversified; it has about 18% in the information technology sector, compared to ITA’s 3% weighting.

The PowerShares fund also spreads its holdings across more companies: PPA invests in 59 companies compared to 31 for ITA. Honeywell (HON), the fourth largest holding for PPA, is nowhere to be found on the list of ITA’s holdings.

Sector ITA PPA
Industrials/Materials 96% 78%
Technology 3% 18.
Consumer Discretionary 1% 4%

Performance and Expenses

Both the funds have produced similar returns over both 2009 and the last 52 weeks. ITA has slightly outperformed PPA in 2009, but PPA the edge over the past 52 weeks. Both funds have underperformed the broad market (as measured by SPY) in 2009, but are ahead over the past 52 weeks.

ITA has a lower expense ratio, coming in at 0.48% compared to PPA’s 0.60%.

ITA PPA
YTD Return* 17.97% 16.94%
52 week Return* 24.21% 26.29%
#1 Holding United Technologies Boeing
#2 Holding Boeing United Technologies
Expense Ratio 0.48% 0.60%
*As of October 15, 2009

Verdict

While there are definite political risks involved with investing in these types of firms, the majority of the holdings have diversified product bases that can play off of both the civilian and military aerospace and defense sectors. Although there are pros and cons to both ETF strategies, investors that prefer more targeted exposure to the aerospace and defense industries may favor ITA, while those that are looking for a more diversified fund may lean toward PPA.

Disclosure: Long ITA

Source: Bullish Predictions for Aerospace & Defense ETFs