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It is very important for a diversified portfolio to have a few holdings that are likely to go up in the face of a stock market crisis. One obvious example of this type of portfolio component is gold. Other, less obvious examples of this strategy are companies in the defense industry.

The Sept. 11, 2001, attacks changed a lot of things, including how important it is to have exposure to the defense sector. After that attack, the government told us repeatedly to expect more attacks. Whether there will be more attacks is unknowable, but I do know that the government has not given any sort of all-clear sign, nor is it likely to.

The situation in Iran, as portrayed in the media, seems to have escalated in the last few days. So between Iran, Iraq and North Korea, there are plenty of current events that will keep our military busy for a while to come. This creates a visibility for increased defense spending in the future, and more spending is a tailwind that could make defense a leader among the industrials.

Some of the defense stocks are very volatile, and that makes it difficult to pick individual names in that part of the market. However, PowerShares offers an exchange-traded fund for investors who want this type of insurance but do not want to pick stocks: the

PowerShares Aerospace and Defense Index Fund

(PPA) - Get Invesco Aerospace & Defense ETF Report

.

As an example of the security that defense can offer a portfolio, during the Sept. 11 catastrophe and its aftermath, exposure to the defense sector would have reduced losses, as most defense stocks went up dramatically.

When the market reopened on Sept. 17, 2001, the S&P 500 dropped 4.9%. Two weeks later, the S&P still had not started its climb back up.

Northrop Grumman

(NOC) - Get Northrop Grumman Corporation Report

,

General Dynamics

(GD) - Get General Dynamics Corporation Report

and

L3 Communications

TheStreet Recommends

(LLL) - Get JX Luxventure Limited Report

had gains of 15.6%, 9.1% and 22%, respectively. on Sept. 17, and by Oct. 1, 2001, all three had added to those gains slightly.

While the defense exposure is essential, the PPA ETF is not 100% invested in defense. Tying into the aerospace part of the name, 17% of the fund is in more consumer-oriented names, including

Sirius Satellite

(SIRI) - Get Sirius XM Holdings, Inc. Report

and

XM Satellite

(XMSR)

, as well as satellite TV stocks; 14% is in defense-oriented technology stocks such as

Computer Sciences

(CSC)

. The vast majority, 64%, is in heavy industrial stocks that make planes, guns, bullets, tanks and body armor.

PPA has been trading only since October, but there are long-term chart data for the Spade Defense Index (DXS), which underlies PPA. Even though PPA is not 100% defense, it has a very tight correlation to the purer Philadelphia Defense Index (DFX).

Given DXS's heavy weight in industrials, its chart also looks similar to the broad industrial sector, as measured by the Industrial Sector SPDR (XLI), but the narrow defense exposure has allowed DXS to outperform.

How Defense Stacks Up Against Broader Industrial Sector
The Philadelphia Defense Index (DFX) and Industrial Spyders (XLI)

Source: Your Source Financial

In trying to work this into a diversified portfolio, PPA takes on characteristics of the industrial sector. It has an average market cap of $18 billion, which skews it to more of a mid-cap holding. In its short history, PPA has paid one 21-cent dividend.

It is worth noting that PPA has very little volume, averaging only 11,000 shares per day. Usually, low volume is not too much of an obstacle for individual investors, but I would still suggest limit orders, in the name of safety.

At the time of publication, Nusbaum was long NOC as a client holding, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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