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Over the past few months, one of the key issues that has been facing the U.S. is the enormous budget deficit and how best to get this debt under control. The U.S. has already lost its prized ‘AAA’ credit rating according to S&P and it appears that others may follow if more steps aren’t taken to reign in spending. Thanks to this, a legislative ‘supercommittee’ has been set up in order to find ways to cut spending, while at the same time, allowing the nation to grow. The task is pretty immense as the 12 person group is supposed to somehow agree on an additional $1.5 trillion in savings over a ten year period, not an easy find given how deadlocked and partisan our Congress has become.

Nonetheless, one of the first places that lawmakers will probably look at will be in the Defense Department. “”Overall defense spending accounts for 20% of the entire federal budget. Last year, the Pentagon spent $530 billion, without even counting war costs” writes Charles Riley of CNN Money. “Already, the debt ceiling deal struck by the nation’s top lawmakers includes $350 billion in cuts to the defense budget over the next decade,” so further cuts cannot be ruled out for this enormous industry, especially considering how unlikely cuts to entitlement programs are in the current weak economic environment.

Furthermore, defense spending as a percentage of GDP is well above many other developed nations around the world by a large margin. The U.S. spends nearly twice as much as a percentage of GDP as France and the UK, while it spends close to four times as much as Germany and Japan. In terms of overall dollars, no other nation even comes close; the U.S. spends close to six times more than China and almost as much as every other nation on Earth, combined [read Rare Earth Metal Shortage Could Sink These Three ETFs].

Given how lopsided the spending is in the U.S., many are likely to go along with a cut in defense spending, especially if the only other alternative is a cut in medicare or social security. Indeed, beyond entitlement programs, defense is the single largest expenditure for the government, and since it isn’t quite as much of a political hot-button issue, some look to the sector as one for huge cuts. In fact, according to a recent report, the top five defense contractors raked in revenues of close to $40 billion in 2009 from the government, making for an easy target for many politicians seeking to appeal to ‘Main Street’ ahead of next year’s elections.

Not So Fast!

Yet, before harsh cuts can take the sector down a peg, a number of roadblocks will have to be dealt with. First and foremost is the loss of jobs that a large cut in defense spending would necessitate. Defense is one of the few industries that is still on American shores so a large reduction in government spending in this area could crush this corner of the manufacturing base, leaving many factory workers unemployed. This could be politically difficult to deal with given the current employment situation and could force some to take another look at other areas of the budget.

Secondly, and just as important, the U.S. remains engaged in a number of conflicts around the globe so a cut in spending could not be welcomed news by those seeking replacements for parts or new high tech weapons for the battles. In essence, a large amount of the spending seems necessary if the U.S. wants to continue to have an interventionist foreign policy. Given the forays into nations such as Libya in recent months, this doesn’t exactly seem too far fetched. Furthermore, as Army Gen. Marin Dempsey said recently, “national security didn’t cause the debt crisis nor will it solve it.”

Ways To Play

No matter what happens, the defense industry will be one to watch over the next few months, and especially so as the budget crisis unfolds. If deep cuts hit the industry hard, firms are likely to see stock prices crater, and they could remain depressed if it appears to be a long-term shift instead of a short-term budget reshuffling. On the other hand, if the industry is able to skirt by relatively unscathed, investors could breathe a sigh of relief and resuming buying the sector in droves, making now an ideal time to purchase firms in the aerospace and defense industry.

For investors looking to achieve broad exposure to the sector, there are currently two choices that could make for great ways to play the industry long or short. While both funds offer similar holdings and strategies there are a few key differences that investors need to be aware of before making a choice between the two [also try out our free compare tool to analyze any two ETFs head-to-head]:

  • iShares Dow Jones U.S. Aerospace & Defense Index Fund (ITA)- This iShares product is slightly cheaper, and more popular, than its PowerShares cousin, charging investors .48% a year in fees. The fund holds 33 securities in total and gives heavy weightings to United Technology Group (UTX), Boeing (BA), and Precision Castparts (PCP). Year-to-date the fund has lost about 8.5% but has gained about 3.6% over the past 52 weeks. However, investors should also note that the fund has a slightly higher beta and PE suggesting it may be more of a growth-oriented product [see returns of ITA here].
  • PowerShares Aerospace & Defense Fund (PPA)- Although PPA might be more expensive, the fund does offer a wider base of exposure, giving investors access to more than 50 companies in total. PPA’s top holdings are flipped from ITA, giving the top spot to Boeing and the following it up with UTX. In third, Honeywell makes an appearance, a fund that doesn’t even receive inclusion in ITA’s top ten holdings. PPA’s return so far in 2011 hasn’t been great, as the fund has fallen by about 12.3% since the start of January. Longer term isn’t much better as the product is down for both the recent one and three year periods as well. With that being said, the fund does offer a lower PE by nearly two and has a standard deviation that is less than half of ITA, suggesting it could be a less volatile pick in these rocky markets.

Disclosure: Long ITA.

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Source: Can Defense ETFs Survive A Spending Slowdown?