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Is It Time to Buy The Airline ETF (FAA)?

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The airline industry continues to face challenges from concerns related to business travel and oil prices and the seemingly never-ending market turmoil. The major threat to the airline industry is fuel price volatility, which is, besides hedging techniques, beyond the control of airlines (Read: Airline ETF Hits Turbulence On Oil Surge).

While higher oil prices make aircraft operations expensive, lower prices indicate a slowing economy and result in a fall in global air travel demand.

The fluctuating trend in oil prices and mounting tension over Iran and the other Middle East nations are keeping airlines under pressure (Read: Three ETFs For An Iranian Crisis). Added to these concerns are broad fears of oil price increases in the second half of the year and declining demand from key emerging nations which had been making up the bulk of air travel increases in the recent past.

Beyond these emerging market woes, developed markets aren’t much better, especially in the case of Europe. Despite a number of bailouts, Europe’s woes are intensifying with all eyes on Greece, Spain and Italy as they attempt to stop the slide in their economies (Read: Spanish Bailout: Did It Help European ETFs?).

In fact, threats of a recession are also looming on the economy at large. In such scenario, the warning of a drop in air travel demand would jeopardize airlines, thereby hurting the performance of the airline stocks and any ETF with exposure to the sector (See more ETFs in the Zacks ETF Center).

Robust Airline Outlook

Challenges notwithstanding, the airline industry has been a solid segment of the industrial sector so far this year (Read: Three Industrial ETFs Outperforming XLI). This is because the airlines are well positioned to endure the prevailing crisis situation and ready to face the burden of slowly rising oil prices. Successfully passing on the increased costs to customers in the form of fare hikes and efficient use of fuel-hedging strategies are effective tools to combat the pressure, and the prolonged period of relatively low prices has certainly been helpful to these firms so far in 2012.

Further, the airlines are reducing their capacities and replacing their older fleet, which are no longer feasible in a fuel-expensive environment, with the latest fuel-efficient aircraft. This move looks to save fuel cost to a certain extent. Besides, they are adding novel features to their services and introducing new products to enhance their value and profitability such as wi-fi and satellite TV options.

Moreover, a booming e-commerce market, airport expansion plans and development in western China are leading to robust airfreight growth in emerging markets. With new airlines business and advanced technology, the demand for flying is also on the rise. About one-thirds of the demand is expected to come from Asia that will likely offset the weak demand in Europe and the U.S. (Read: Play Europe with This ETF Pair Trade)

These strong aspects make the airline sector an intriguing option to play at present. Investors have only one ETF to play in this slice of the industrial market which offers broad exposure to the space:

Guggenheim Airline ETF (FAA)

Launched in January 2009, the fund has held up nicely so far this year, producing double-digits gains. It seeks to replicate the price and performance of the NYSE Arca Global Airline Index, before fees and expenses.

With AUM of $17.3 million, the ETF has about 26 securities in its basket, with airlines from around the world. Major U.S. airlines like Southwest Airlines Co. (LUV), United Continental Holdings Inc. ((UAL - Free Report) ) and Delta Air Lines Inc. ((DAL - Free Report) ) dominate the top three spots, making up for a combined 44% of the share.

In total, international airlines comprise for about 29% of the fund giving the product high levels of exposure to foreign air travel as well. Additionally, the product provides excessive exposure to mid-cap companies, though nearly 38% of the assets come from large and small caps. (Read: Mid Cap ETF Investing 101)

The fund has more than 95% correlation with the developed markets and 5% with the emerging markets. From the country exposure look, the fund is heavily exposed to United States with 70% of the assets, followed by Germany, Japan, South Korea, Panama, Spain, Ireland, Brazil, Sweden and Australia.

The fund is liquid as it trades in good volumes of about 10,000 shares on a daily basis (Read: Guide to the 25 Most Liquid ETFs). Though the product is quite expensive with an expense ratio of 0.65%, it does have a relatively wide bid ask spread which could add to total costs for traders.

The fund has returned about 17% in the first half of the year and yields about 0.97% dividend per annum. While the yield is far less than that of the broad industrial sector, the capital gain performance has been quite strong, far outpacing broader funds in the similar time frame.

Should oil prices remain at moderate levels and if both emerging and developed markets can continue to hold up nicely, investors could see this trend continue, although it could be a turbulent ride for the airline industry as we close out 2012.

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