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ETF News And Commentary

Despite the uncertainty related to sequestration, huge defense budget cuts, and cancellation of big-ticket programs, the global aerospace and defense industry has nicely held up so far this year. This is largely attributable to technological innovations, big contracts, acquisitions and growing commercial demand.

Since the domestic aerospace and defense sector is facing budget cuts and a constrained spending environment from the U.S. government, the industry is looking for growth from international orders.

Additionally, a number of new emerging markets as well as developed nations, such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil, are boosting defense spending and generating business for the U.S. aerospace and defense companies.

Still, the U.S. is the leader in global defense spending. The country is not only a major superpower, but it also has strategic alliances with other foreign nations that have major military strengths and geopolitical concerns.

The country sometimes shares its military technology and supplies sophisticated weapons to its allies. These activities in turn boost the revenue of the defense operators and suppliers who sell these military applications to nations around the world (read: Any hope for Aerospace and Defense Industry ETFs in 2013?).

However, on the flip side, the industry's position is challenged by global competition, changes in technology, national and worldwide economic conditions, and global policies affecting defense, civilian and commercial aviation. Going forward, the industry, in particular the defense sector, will face challenges as the federal government will look for solutions to the ongoing budget crisis.

Further, sequestration still remains an overhang both in the civil and military sectors. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration. On the other hand, those with an international order book would find it less difficult to face the brunt of sequestration (read: With Sequester Ahead, Are Defense ETFs in Trouble?).

Overall, the industry has been performing well compared to other sectors, so investors seeking diversification should consider ETFs that target the aerospace & defense industry in the portfolio.

Considering the broad issues and opportunities, a look at top ranked aerospace & defense ETFs could be a winning choice for investors seeking to benefit from the positive market trends. One way to find a top ranked ETF in the financial space is by using the Zacks ETF Ranking system (read: Zacks ETF Rank Guide).

About the Zacks ETF Rank

The Zacks ETF Rank provides a recommendation for the ETF in the context of our outlook for the underlying industry, sector, style box, or asset class. Our proprietary methodology also takes into account the risk preferences of investors. ETFs are ranked on a scale of 1 (Strong Buy) to 5 (Strong Sell) while they also receive one of three risk ratings, namely Low, Medium or High.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of five ranks within each risk bucket. Thus, the Zacks Rank reflects the expected return of an ETF relative to other products with a similar level of risk (see more ETFs in the Zacks ETF Center).

For investors seeking to apply this methodology to their portfolios in the aerospace and defense sector, we have taken a closer look at the top ranked XAR, which has a Zacks ETF Rank of 1 or Strong Buy with a Low risk outlook. The details of this outperforming fund are highlighted below:

SPDR S&P Aerospace & Defense ETF (XAR - ETF report)

Investors seeking exposure to the U.S. aerospace & defense market may find XAR an intriguing choice. Launched in September 2011, this is the most recent addition in the aerospace & defense ETF world. The fund seeks to match the price and yield of the S&P Aerospace & Defense Select Industry Index, before fees and expenses.

With holdings of 34 stocks, the fund is somewhat concentrated in certain individual securities as it puts roughly 46% of assets in the top 10 firms. Northrop Grumman (NOC - Analyst Report), Boeing (BA - Analyst Report) and Spirit Aerosystems (SPR) take the top three spots in the basket with 4.8% share each.

The product has its assets invested across all classes of the market spectrum. Large caps accounts for 37% of XAR while mid and small caps take 30% and 33% share, respectively. Further, the fund has a nice mixture of blend, growth and value securities, ensuring broad diversification in terms of style (read: The Best Investing Style ETF This Fiscal?).

The ETF charges investors 35 bps in the form of fees and expenses, the lowest among the three ETFs in the space (the others being (ITA - ETF report) and (PPA - ETF report). However, the product has amassed just $14.8 million in AUM and trades in a paltry average daily volume of less than 2,000 shares. This increases the total cost of the product in the form of a wider bid ask spreads.

Although the ETF does not appear to be popular, its performance has been quite remarkable. XAR is the best performing ETF among the three, delivering a robust return of 31.7% over the trailing one year period and 16.6% in the year-to-date time frame.

The fund also yields 1.72% in annual dividends, suggesting that it is a decent yield play too. These incredible returns make the fund an attractive choice in the industrial space, and imply that the aerospace and defense market is quite resilient in the face of broader market troubles (read: 3 Sector ETFs Surviving This Slump).

Further, it is less volatile as indicated by its annualized standard deviation of 19.15%. Despite the fund’s relatively moderate concentration (12.02% as per xtf.com), the aerospace and defense ETF still could be a solid choice for investors, and one that can definitely fight through weakness to surge higher in the weeks and months ahead.

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