Defensive ETFs And Budget Talks

Though the fiscal cliff ordeal was somewhatsuccessfullyavoided, Washington has yet another hurdle to face in the coming months: budget talks. Back in January, the last minute dealcobbled together by Republican leader Mitch McConnell and Vice President Joe Biden raisedincome tax rates for those earning over $450,000. The tax hikes are expected to reduce the deficit by some $620 billion over 10 years, far less than Obama's $4 trillion in deficit reduction goal.Though the American public might have sighed in relief, government spending was one crucialelement that was not addressed in the New Year's deal .

Who Gets the Axe?

Come March 1, 2013 an automatic round of roughly $65 billion in spending reductions will take place if Congress does not agree on fiscal budget. Should a bipartisan agreement not be reached, the following four main areas will be cut:

• Military spending cuts: $54.7 billion, or 7.5%
• Medicare: 2% cut in payments to providers
• Other Mandatory programs: 8% across the board cuts
• Other non-defense Discretionary programs: 8.4% cut

Already, companies in these industries are feeling the pressure as the potentially severe budget cuts will have material impact on bottom line returns. Defense manufacturing giant Lockheed Martin (LMT) has already reported a slide in net profit for the fourth quarter of last year after the company was forced to slow production and cut several hundred jobs when the U.S. government cut the number of F-35 jet fighters it plans to buy .

Aerospace & Defense ETFs: Caution Ahead

As the threat of sequestration makes choosing the right investments difficult in the next few months, investors should keep a close eye on the industries that will be most affected by government budget cuts. Below, we highlight three aerospace and defense ETFs that may be in for a volatile ride in the near future:

• iShares Dow Jones U.S. Aerospace & Defense Index Fund : This ETF has roughly $80 million in total assets under managementand invests in a basket of about 35 individual securities. Top holdings include United Technologies (UTX), Boeing (BA) and Precision Castparts (PCP).
• PowerShares Aerospace & Defense : In terms of size, PPA is significantly smaller than the more popular ITA, though the fund does cast a wider net over the space with its portfolio of 50 aerospace and defense stocks. Industry giants Boeing (BA),Lockheed Martin (LMT) and Honeywell International (HON) account for roughly one-fifth of PPA's total assets .
• State Street SPDR S&P Aerospace & Defense ETF : Comprised of roughly 35 individual holdings, this ETF provides much more balanced exposure to the industry than ITA and PPA. Using an equal-weighted methodology, no individual stockreceivesmore than a 4.7% allocation. Top holdings include TransDigm Group (TDG), Spirit AeuroSystems Holdings (SPR) and Hexcel Corporation (HXL).

Disclosure: No positions at time of writing.