The Q1 earnings season was a bit of a dampener for the aerospace and defense sector. It was a stronger dollar as well as a tepid budget that weighed on revenue results. With all the companies having reported their first-quarter numbers, 55.6% have beaten earnings estimates while only 44.4% could surpass top-line expectations. The sector’s earnings grew by a meager 0.7% and revenue by 2.7%.

Nonetheless, there was some improvement on the guidance front. A combination of cost-cutting, share buybacks, mergers and acquisitions, restructuring as well as earnings gains from businesses outside the federal market has helped to minimize investors’ losses (read: 2 ETFs on Watch as Aerospace & Defense Scores Modest Q1 Results). 

Given the budget sequester slashing the Department of Defense’s budget by billions of dollars the U.S. aerospace and defense industry has held up strongly. Year to date, the Dow Jones U.S. Aerospace and Defense Total Stock Market Index increased 5.03%, outperforming the S&P 500 index (SPY) of 3.14%.
 
The U.S. is in the thick of a new arms battle in the Middle East, as increased sectarian fighting and proxy wars in Yemen, Syria and Iraq create new demand for advanced weapons and weapon systems. Hence, at the macro level, there has been a gradual shift in defense spending patterns. In response to asymmetric terrorist threats, the emphasis appears to have shifted to high-tech intelligence equipment, replacing demand for conventional big guns and heavy armor (read: Top Ranked Sector ETFs to Buy for Summer).
 
Moreover, the Obama administration’s new plans for the international export of U.S. military drones, including armed drones, to U.S. allies are an added catalyst for the domestic defense contractors. Most importantly, foreign military sales still remain the life line for the defense companies as rising geopolitical tensions have pushed up demand for U.S. weapons exports, eventually benefiting the domestic defense manufacturers. In fiscal 2014, U.S. military sales to its allies stood at $34.2 billion, according to the Defense Security Cooperation Agency. This marked a 14% increase from the fiscal 2013 level.
 
Meanwhile, elevated geopolitical risk appear to be fueling support in Washington for an increase in fiscal 2016 defense spending above sequestration caps.
 
That said, factors including declining demand amid global growth worries, strength in the U.S. dollar and intense competition had a negative impact on the earnings results of some of the companies from this sector. The aerospace sector’s Q2 earnings are expected to decline 7.3% as against 0.7% growth in the preceding quarter. (read: Will Defense Industry Be Hit by Global Slowdown?).
 
ETFs to Tap the Sector

Below, we highlight the ETFs in the aerospace and defense sector, which primarily have a U.S. bias. Investing in these funds in basket form greatly reduces the risk of investing in particular stocks.  (See all industrials ETFs here)

iShares U.S. Aerospace & Defense ETF (ITA - ETF report)

With a Zacks ETF Rank #2 (Buy), ITA has provided a positive return of 15.18% over the one-year period ended Mar 31, 2015. This fund tracks the Dow Jones U.S. Aerospace & Defense Index, providing exposure to companies related to the aerospace and defense industry in the U.S. equity market.

This index has a 100% focus on U.S. companies. The fund has an annual dividend yield of 1.36%.

The ETF, launched in May 2006, presently has nearly $562.6 million in AUM and is heavily weighted toward the Industrials sector (97%) with the balance going to Technology. This fund holds 37 stocks with about 54.35% invested in the top 10 holdings.
 
Among individual holdings, the top stocks in the ETF include United Technologies Corp. (UTX), The Boeing Co. (BA) and Lockheed Martin Corp. (LMT) comprising 8.29%, 7.97% and 6.19%, respectively, of total net assets. With a lilt toward medium-cap companies, this fund charges investors 44 basis points a year.
 
Aerospace & Defense Profile (PPA - ETF report)
 
This ETF tracks the SPADE Defense Index, holding 55 securities in its basket and has an expense ratio – an annual fee – of 0.66%. The Index is designed to identify a group of companies involved in the development, manufacturing, operations and support of U.S. defense, homeland security and aerospace operations. The index was launched in October 2005.
 
This fund has a Zacks Rank #2 and is highly focused on U.S companies (about 99%) with the balance on Europe. The fund so far has managed assets of $270.4 million with focus on large-cap companies. The top 10 companies hold a 52.83% share of total net assets. The average daily volume is about 54,775 shares and the fund has an annual dividend yield of 0.74%.
 
In terms of holdings, Honeywell International Inc. (HON), United Technologies Corp. and The Boeing Company occupy the top three positions in the basket comprising 6.60%, 6.44% and 6.14%, respectively, of total net assets.
 
SPDR S&P Aerospace & Defense ETF (XAR - ETF report)
 
This fund follows the S&P Aerospace & Defense Select Industry Index, focusing on the aerospace and defense sector of the S&P Total Market Index. The Index is one of 19 S&P Select Industry Indices, each designed to measure the performance of a narrow sub-industry or group of sub-industries as defined by the Global Industry Classification Standards.
 
With a Zacks ETF Rank #2, this fund charges investors just 35 basis points a year in fees for its exposure. Hence, it is considered the cheapest option in the aerospace and defense ETF market.
 
With holdings of 36 stocks, the top spots are taken up by TASER International Inc. (TASR), Alliant Techsystems Inc. (LNT), and Huntington Ingalls Industries Inc. (HII), comprising 3.64%, 3.58% and 3.46%, respectively, of total net assets.
 
Launched in September 2011, this index has 100% focus on U.S companies.
 
The fund so far has managed assets of $158.1 million and has an annual dividend yield of 1.19%. The top 10 companies hold a 37.74% share of total net assets. The average daily volume is about 11,607 shares.
 
To Sum Up
 
In spite of the difficult budget scenario, the aerospace and defense sector is holding up well. The defense biggies are proactive in meeting evolving customer needs, particularly for affordable products, besides engaging in corporate restructuring. Moreover, tensions in Eastern Europe and demand for defense products in the Middle East and other Asian nations ensure a flow of foreign contracts. In this context, the above mentioned ETFs with favorable Ranks might be a good idea to play defense.