3 ETFs Covering The Defense Industry
Summary PPA offers the broadest, most diverse portfolio, extending its coverage to cybersecurity and communications, but at a cost. ITA offers the highest dividend yield, but also seems to lack the performance edge of the other funds. XAR has a small portfolio, and has the fewest assets of the three, but may have performance advantages. Given current world tensions, there is no wonder one of the major concerns in Washington, D.C. (particularly Republican legislators) is national defense; in particular, there is a great desire to increase military spending, with both parties seeking ways to add more funds to the defense budget, differing only on how much and how to account for it. 1 It seems like a good time to review one’s holdings in the area of defense, and it also seems that a good way to cast a wide net over this industry segment is with an ETF. There are currently three that focus on aerospace and defense (A&D): PowerShares Aerospace & Defense Portfolio ETF (NYSEARCA: PPA ) iShares U.S. Aerospace & Defense ETF (NYSEARCA: ITA ) SPDR S&P Aerospace & Defense ETF (NYSEARCA: XAR ) Comparison These funds are offered by three of the major ETF sources, and they show it. The smaller of the three – XAR – weighs in at more than $100 million in assets; it is also the youngest of the three (relatively speaking), having its inception in 2011. Blackrock (NYSE: BLK ) gives its iShares offering, ITA , typical heft with a $458 million in assets under management. PPA brings a NAV of nearly $230 million. XAR also has the lowest expense ratio (0.35%) of the three, with ITA next lowest (0.45%) and PPA coming in with a just-above-average ER of 0.66%. 2 In more practical terms, ITA has an expense margin (EM) of 74.83%, compared to XAR’s EM of 72.50% and PPA’s 58.78% EM. 3 The three funds overlap on 27 companies – something one would expect given the tight focus of the associated indices. Moreover, eight of those companies show up in the top-ten holdings of each of the funds: The Boeing Company (NYSE: BA ) Rockwell Collins Inc. (NYSE: COL ) General Dynamics Corporation (NYSE: GD ) Lockheed Martin Corporation (NYSE: LMT ) Northrop Grumman Corporation (NYSE: NOC ) Precision Castparts Corp. (NYSE: PCP ) Raytheon Company (NYSE: RTN ) United Technologies Corporation (NYSE: UTX ) Of the three funds, ITA and XAR are the most similar. Both are guided by similar indexes – that is, to the extent that the S&P index used by XAR and the Dow Jones index employed by ITA can be said to be “similar.” ITA has the larger portfolio – both in terms of number of holdings and assets – but in addition to the 27 companies they have in common with each other and with PPA , ITA and XAR overlap on an additional five holdings. In this respect, the two funds are almost identical. All three funds make their selections based on market cap , with ITA and XAR also introducing liquidity considerations. The funds are rebalanced quarterly. By way of contrasts, PPA and XAR each has an aspect with respect to which it differs from the others in the group. PPA defines A&D in broader terms than the other two funds, allowing it to define a larger universe of prospective holdings and resulting in a significantly larger number of holdings than either ITA and XAR . The broader concept of A&D adds companies in communications and cybersecurity to the mix; the portfolio is therefore more diverse and less focused than that of the fund’s competitors. While both PPA and ITA are cap-weighted funds, XAR is equal weighted. As I have written elsewhere, I do have a preference for equal-weighted funds; 4 research indicates that, over the long haul, such funds tend to outperform cap-weighted funds – indeed, they tend to be among the best-performing funds. The boost is due to the fact that equal-weighted funds put more emphasis on mid – and small – capped companies , which are more likely to see significant growths in share value than large-capped firms. At the same time, however, the greater exposure to small-capped holdings – in particular – adds an increased element of volatility . Performance All of the funds have enjoyed fairly consistent growth since their inceptions, as illustrated here: (click to enlarge) Of course, ITA and PPA both had to contend with the recession from 2007 – 2009, and ITA seems to have been particularly hard hit. All three funds have managed to more than double their share values. A direct comparison of performance on the basis of price is not easy, given the differences in share prices, but the following chart looks at the funds’ performance: (click to enlarge) All three funds seem to be following the same general trend, and it seems doubtful that PPA ‘s broader focus has made any significant improvement in performance (although it does perform somewhat better than the other two funds). For a more direct comparison of the three funds the following chart compares their performance since the inception of XAR : (click to enlarge) What I find interesting here is that both ITA and PPA are very close in performance, with PPA having a roughly 320bps edge over ITA (due to the larger number of holdings?). But note that XAR significantly outperforms the competition; it currently has a 1335bps lead over PPA , and that is down from its position at the beginning of 2015. 5 Since XAR has the smallest portfolio of the group, it is not size that counts; furthermore, the three funds overlap on a significant part of their holdings – particularly between XAR and ITA – making it less likely that the particular holdings of the funds is the cause of the difference in performance. I am drawn to the conclusion that XAR’s weighting scheme is the important factor in its performance. The following chart illustrates the funds’ performance year-to-date: (click to enlarge) What is interesting to note here is that while XAR was outperforming the other two funds for most of the year (so far), after the dramatic drops realized over the past summer XAR is actually performing at a lower level than the other two funds. This gives us a rather dramatic illustration of the downside to equal weighting. Assessment I am increasingly becoming a big fan of equal weighting. All things considered, I find XAR to be the best of these three funds. It has a trim portfolio – especially compared to PPA’s 53 holdings – and its equally weighted portfolio seems to have a marked edge over the more standard, cap-weighted portfolios offered by PPA and ITA . Someone wanting to cast a broader net over the defense industry might prefer the more open focus of PPA . That broader focus does come at a price, as PPA offers the lowest dividend yield of the three. This may be due to the fact that cybersecurity firms often do not pay dividends, but the just-under-$230-million NAV and seven million shares outstanding certainly don’t help here. I do not think that the difference in dividends between PPA and ITA outweighs the performance edge PPA seems to have, however. PPA does have a very high ER , and does seem to be more lightly traded than either ITA or XAR . For its part, ITA offers the typical BlackRock advantage: size . It is by far the largest ETF in terms of AUM. Its cap-weighted scheme, along with the assets it has to back that up, pretty much assure shareholders of regular dividends . The fact that it has only roughly 4.5 million shares outstanding (compared to PPA’s seven million) means the distributions are not going to be overly diluted. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from Yahoo! Finance . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 On October 1, for instance, House Republicans approved a $612 billion defense authorization bill (” House passes sweeping defense policy bill ,” Reuters, October 1, 2015), a bill President Obama has promised to veto. The President seeks a more modest increase in spending, suggesting a base budget of $534 billion, with an additional $51 billion in “war funds” (” Defense chief says Obama likely to veto defense policy bill ,” Reuters, September 30, 2015). 2 Expenses have been averaging around 0.62%. ” ETF Fees Creep Higher ,” Rick Ferri, Forbes.com . According to Ferri, figures indicated that since the 1990s, ERs have been gradually increasing. 3 For those unfamiliar with my use of “expense margin,” this is what I consider to be the ETF’s equivalent of “operating margin”: it is the cost of the ETF’s doing business. To determine the EM divide the actual net income realized by the ETF by the ETF’s gross income. One could replace net income with total distributions to shareholders. Essentially, the idea is to determine how much of an ETF’s income is passed on to shareholders. I discuss the issue in detail in my article ” Ignore ETF Expense Ratios? Maybe. ” As a practical application, consider that while XAR has a lower ER than ITA, it actually distributes smaller proportion of its gross income than ITA does. Since XAR’s expenses are lower, one would suspect that it does not realize as much income (proportionately) as ITA. 4 ” Guggenheim s RSP: Equal Weight Or Dead Weight? ” 5 At XAR’s high point for this year (10 April), it was up 153% since inception; PPA was up 148.96% since its inception; ITA was up 141.27% from its starting point. More impressively, starting all three funds from XAR’s inception date through 10 April 2015, XAR was up 153.30%, PPA was up 124.49% and ITA was up 125.48%.