Defense: Not Necessarily the Best Offense

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I'm having trouble finding a fund that holds mostly defense industry stocks. What can you tell me?

QUESTION: I'm having a difficult time trying to find a mutual fund that handles mostly defense-industry stocks, i.e., Boeing, Lockheed, etc. Do you have any information on this subject?

ANSWER: In a sense, you're in luck: At least one mutual fund — and perhaps two — fit the bill. Fidelity Select Defense & Aerospace (FSDAX) invests the majority of its assets in companies involved in defense or aerospace. Its sibling, Fidelity Select Air Transportation (FSAIX), also delves heavily into that realm. Both count Boeing (BA) and Lockheed (LMT) among their 10 largest holdings.

But caution is in order: Before you put your money on the line, consider whether you already have sufficient exposure to the defense arena through your existing mutual-fund holdings. That might not be a problem if you also have an index fund tied to the Standard & Poor's 500, since only 0.96% of the index is occupied by aerospace and defense stocks. But the growth-oriented Janus fund (JANSX), the nation's sixth-largest fund overall, currently invests 4.34% of its assets in the sector, mainly via Boeing and Lockheed. For most investors, that's probably plenty.

As for investing in a pure-play defense-stock fund, keep in mind that sector funds should represent a small portion of your total portfolio, says Scott Cooley, an analyst at fund-tracking firm Morningstar. This is particularly important when it comes to defense, he adds, since a portfolio focused on such a narrow swath of the market could actually qualify as a "subsector fund," making it even riskier than, say, a fund of diversified industrial stocks.

Cooley also cautions against using such funds as short-term plays, notwithstanding the Bush administration's defense-friendly attitude. "The thing to keep in mind about defense stocks is, they had a pretty good run last year," says Cooley, so a lot of the expected improvement in their business could already be priced into them. Aerospace stocks, for example, returned approximately 70% over the past year, and are breaking even year-to-date.

What investors can anticipate is that a fund such as Fidelity Select Defense & Aerospace will likely take them on a roller-coaster ride as defense stocks move in and out of favor. The portfolio's volatility is almost 25% higher than that of the S&P 500 index. Still, its long-term returns are good. Over the past 10 years the fund turned in an annualized gain of 17.38%, edging past the S&P 500's 17.35%. Over the past three years, it has delivered a more modest 7.05% annualized, but it recently gained steam again, returning 33.34% over the past 12 months.

Fidelity Select Air Transportation, which also provides plenty of exposure to the defense sector, has similarly had a lot of wind beneath its wings. According to its Dec. 31 report, it invests about 40.3% of its assets in aerospace and defense stocks. It has returned 18.84% annualized over the past decade — and a whopping 53.41% over the past 12 months.

One thing to note about both funds is that they have a new manager. Matthew Fruhan, who previously managed Fidelity Select Food & Agriculture (FDFAX), took the reins of both just weeks ago. However, Morningstar's Cooley says that Fidelity's strong recruiting and training processes have ensured good long-term returns among its Select portfolios, even as managers rotate among them.