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Protect Your Portfolio With Defense Funds

The Indianapolis Colts won last season's Superbowl largely because the team unexpectedly fielded a defense that was almost as potent as its deadly passing game.

Until this Sunday when they were edged out by the New England Patriots, that defense helped the Colts maintain a perfect record through the first seven games of this year's campaign.

With the stock market alternatively jumping on interest-rate cuts and running into air pockets on earnings disappointments, a few added defensive stocks for your portfolio wouldn't be a bad idea.

Exposure to defense -- the defense industry, that is -- might be a good way to add some defensiveness to holdings.

After all, U.S. defense spending is hardly likely to fall, given the current tension with Iran and North Korea. And while some presidential candidates would like to wind down our military involvement in Iraq, none has been calling for drastic cuts in overall defense spending.

And since federal spending on defense isn't really a function of corporate profits, you could argue that the defense industry represents, well, a defensive investment opportunity.

The performance of defense stocks in recent years has more closely resembled the explosive Colts offense than that of a grind-out-the-yards-but-don't-surrender-any-turf squad.

Adding to the appeal of companies in the defense industry is that, to the consternation of pacifists, they tend to book relatively heavy overseas sales, thus capitalizing on elevated global military tensions as well as the rising value of foreign currencies relative to the U.S. dollar.

The SPADE Defense Index -- an acronym for "SPAce" and "DEfence" -- has climbed steadily from a value of 1000 at the end of 2002 to recent highs north of 2750. The benchmark has outperformed the S&P 500 in each of the past seven calendar years and enjoys a comfortable lead so far in 2007. Ratings tracks three funds that are pure plays on the sector. (FSDAX) Fidelity Select Defense & Aerospace (FSDAX) is the lone open-end mutual fund defense sector pure play. The fund holds 14 of the 25 largest components of the SPADE index, making up 70.6% of its holdings. The fund's largest holdings are Lockheed Martin (LMT - Get Report) and General Dynamics (GD - Get Report).

The PowerShares Aerospace & Defense Portfolio (PPA), an exchange-traded fund, tracks the SPADE Defense Index. The 25 largest SPADE components account for 83.6% of its value. Its largest holdings are Lockheed Martin and Honeywell International (HON - Get Report).

The iShares Dow Jones U.S. Aerospace & Defense Index ETF (ITA) tracks the Dow Jones index embedded in its name. It holds 15 of the 25 largest SPADE components, which comprise 72.5% of its total net assets. Boeing (BA) and United Technologies (UTX) are the fund's largest holdings.

All three sport the Rating's highest possible grade of A+, placing them in the buy category. Each member of the trio has a return of more than double the S&P 500's 14.56% over the past 12 months. In addition, each has produced double-digit gains for the three-month period ended Oct. 31.

Major Defense Stocks are Widely Held
Funds investing in the 25 largest components of the SPADE index.
Boeing Company (BA) 664 50 26 740 17,284.8
United Technologies Corp (UTX) 773 65 28 866 16,976.2
Honeywell International Inc (HON) 599 52 27 678 10,955.7
General Dynamics Corp. (GD) 499 44 13 556 9,773.3
Lockheed Martin Corp. (LMT) 529 48 18 595 9,648.8
Northrop Grumman Corp. (NOC) 465 49 14 528 8,056.8
Raytheon Company (RTN) 555 54 16 625 7,671.7
Precision Castparts Corp (PCP) 450 40 4 494 6,795.3
Rockwell Collins Incorp. (COL) 300 42 9 351 3,279.8
L-3 Communications Hldgs Inc (LLL) 328 40 16 384 3,209.7
Computer Sciences Corp. (CSC) 308 39 6 353 3,076.5
Garmin Limited (GRMN) 128 21 4 153 2,922.5
Harris Corp. Delaware (HRS) 302 39 6 347 2,814.6
ITT Corp. (ITT) 292 42 7 341 2,507.5
Goodrich BF Company (GR) 299 41 8 348 2,485.8
Alliant Techsystems Inc (ATK) 218 37 10 265 1,884.5
FLIR Systems Inc. (FLIR) 191 32 2 225 1,732.7
Ball Corp. (BLL) 261 43 7 311 1,674.9
Oshkosh Truck Corp. (OSK) 198 33 1 232 1,670.6
Trimble Navigation Limited (TRMB) 218 32 0 250 1,640.4
DRS Technologies Inc. (DRS) 340 33 42 415 1,513.0
URS Corp. (URS) 180 33 0 213 896.7
Moog Inc. (MOGA) 159 23 1 183 792.5
Ceradyne Inc. (CRDN) 209 28 1 238 665.0
SAIC Inc. (SAI) 73 20 1 94 258.4
TOTAL 120,187.7
Source: Ratings

The above table lists open-end mutual funds and ETFs with at least 15% of assets invested in major defense and space industry stocks--defined as the largest 25 components of the SPADE Defense Index. The funds are listed in descending order by percentage holdings of the major SPADE stocks.

The 25 major defense and space stocks are listed in a separate table at the bottom of this page.

No closed-end fund reports portfolio holdings of 15% or more in the 25 major defense and space stocks.

All 13 open-end funds on the list produced returns comfortably in the double digits for the past 12 months, handily outperforming the total return of the S&P 500. All but one of them beat the S&P over the past three months.

Of the eight defense-heavy ETFs with at least a year of performance history, all but one achieved 12-month returns of at least 20%, easily outdistancing the S&P gauge. But of the nine ETFs on the list, only the two pure-play funds exceeded the S&P's performance by producing double-digit returns for the latest three months.

Fidelity Select Defense & Aerospace (FSDAX) A+ 14 945.8 70.6 10.68 33.36
Fidelity Select Air Transport (FSAIX) A- 7 31.6 33.3 5.59 19.54 Vice Fund (VICEX) A+ 10 30.3 26.2 16.39 34.02
Fidelity Select Ind Equipment (FSCGX) B+ 10 19.9 21.3 8.76 30.31
Fidelity Adv Industrials A (FCLAX) B+ 7 68.4 20.1 7.51 25.63
ICON Industrials (ICTRX) D+ 13 20.0 19.8 7.13 30.16
Vanguard Industrials Index Adm (VINAX) A 18 43.6 19.5 5.01 23.06
Fidelity Select Industrials Port (FCYIX) B+ 6 16.7 18.4 7.50 25.93
SunAmerica Foc Lrg-Cp Gr A (SSFAX) D 4 196.7 16.9 15.88 22.88
Chase Growth Fund (CHASX) B- 6 97.7 16.6 14.50 21.89
Franklin Growth A (FKGRX) B- 8 469.8 15.9 8.22 18.02
Brandywine Advisors (BWAFX) C+ 5 39.6 15.6 12.05 31.36
Ancora Equity Fund Class C (ANQCX) B+ 5 2.6 15.0 7.86 19.12
PowerShares Aerospace & Defense Portfolio (PPA) A+ 25 204.4 83.6 10.85 36.66
iShares DJ US Aerospace & Def Idx (ITA) A+ 15 152.2 72.5 11.45 40.49
Industrial Select Sector SPDR Fund (XLI) A- 11 295.3 27.6 3.41 20.41
PowerShares Dynamic Industrials Sector Portfolio (PRN) U 12 13.6 25.3 4.96 26.45
Rydex S&P Equal Weight Industrial ETF (RGI) U 11 1.8 21.9 3.07 N/A
Vanguard Industrials ETF (VIS) B+ 18 43.6 19.5 4.23 22.96
iShares Dow Jones U.S. Industrial Sector Index Fund (IYJ) B+ 21 57.8 17.7 4.50 22.11
PowerShares FTSE RAFI Industrials Sector Portfolio (PRFN) U 16 7.4 17.2 2.99 20.22
Dow 30 Premium & Dividend Income Fund (DPD) C- 3 34.4 15.0 0.19 4.38
S&P 500 TOTAL RETURN INDEX 14 3.0 6.97 14.56
* "U" is unrated.
** Holdings of largest 25 stocks in the SPADE Defense Index (acronym for "SPAce" & "DEfense") of companies in the defense, homeland security & space marketplace.
Sources: Ratings & Bloomberg (data as of 10/31/2007).

Richard Widows is a financial analyst for Ratings. Prior to joining, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.

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