Returns on Risk

Funds related to defense and homeland security pick up steam.

Companies that sell defense and homeland security-related products and services get a boost when war and terrorists strike. Now, investors can, too.

Ever since the Sept. 11 attacks, the defense sector has outperformed the Standard & Poor's 500 Index, which tracks 500 of the top U.S. companies. While that's bad news for world peace, it's good news for investors in that industry. Financial institutions are offering investors more funds to help them capture those gains.

In October 2005, PowerShares Capital Management LLC, an asset management firm in Wheaton, Ill., launched an aerospace and defense exchange-traded fund. ETFs function like stocks, which means they can be bought and sold throughout the day. But unlike stocks, they represent a range of individual securities. PowerShares' fund is based on the Spade Defense Index (named after the first letters of space and defense) created by Scott Sacknoff, a Washington-based industry consultant. It invests in more than 50 companies in the defense, aerospace and homeland security fields, including Lockheed Martin Corp., EchoStar Communications Corp. and Computer Sciences Corp.

In May 2006, the San Francisco asset management firm Barclays Global Investors launched its own defense and aerospace exchange-traded fund. It's based on the Dow Jones U.S. Select Aerospace & Defense Index, which includes defense and aerospace-related industrial companies. Unlike the Spade Defense Index, it doesn't include companies that sell information technology or telecommunications equipment. Investors poured $47 million into the fund during the first month and a half of its existence, which BGI spokesman Tom Taggart says, is a strong start.

Sacknoff, whose fees depend partially on investments in the PowerShares fund, is blunt in his predictions for the sector's success. Defense and homeland security spending will continue to rise, he says. He points to Pentagon estimates that the Defense budget will reach almost $500 billion by 2010 from its current $420 billion. He adds that more outsourcing of services by the Pentagon will continue to boost the sector even if Iraq war spending declines.

In a presentation to PowerShares in 2005, Sacknoff said investing in the fund serves as a buffer during negative world events such as war and terrorism, because the sector tends to go up in reaction to such incidents, while other stocks are likely to go down.

Of course, positive returns are not guaranteed. In May, the Spade Defense Index dropped by almost 4 percent. Sacknoff attributes the fall to overall market declines. "You'd have to say it's doing fine even though it has gone down," he says.

Investors appear to share that view. Total assets invested in the Spade fund rose to $83.4 million at the end of May from $64.4 million at the end of February. "There's broad appeal because [exchange-traded funds] allow you to get sector exposure without having to pick an individual stock," says Peter Arment, analyst at the aerospace equity research firm JSA Research in Newport, R.I.

Exchange-traded funds typically charge lower fees because they are based on an index and not actively managed through constant stock analysis. PowerShares maintains an expense cap of 0.60 percent per year, or $6 per $1,000 invested, and Barclays levies an expense ratio of 0.48 percent, or $4.80 per $1,000 invested. Fidelity Investments, an international financial services firm, which has offered a defense and aerospace mutual fund since 1984, charges an expense ratio of 0.97 percent, or $9.70 per $1,000 invested.

Excluding expenses and dividends, someone who invested $1,000 in the Spade Defense Index on Sept. 17, 2001, the day the markets opened after Sept. 11, would have earned an additional $1,013 by June 21, 2006. An equal investment in the S&P 500 Index would have generated $146. Betting on warfighters' needs rarely has been so lucrative.