BA - DFEN: A Buy For 2023 But Be Careful In The Next Few Months

2023-03-20 12:12:15 ET

Summary

• The defense sector is certainly one of the most interesting sectors at the moment, and it will remain so in the coming years as well.
• Despite the positive performance of companies in the defensive sector, the ETF has performed poorly during periods of high volatility.
• DFEN's performance in 2023 will be driven mainly by corporate fundamentals.

The Direxion Daily Aerospace & Defense Bull 3X Shares (DFEN) is a leveraged exchange-traded fund that tracks the performance of the Dow Jones U.S. Select Aerospace & Defense Index. This index is composed of companies in the aerospace and defense industry that are listed on U.S. exchanges.

The ETF includes companies involved in the development and production of aircraft, missiles, spacecraft, satellites, and other defense-related technologies and the holdings include some of the largest aerospace and defense companies in the world, such as Lockheed Martin (LMT), Boeing (BA), Raytheon Technologies (RTX), and General Dynamics (GD).

Summary of DFEN companies (Direxion)

Overall, I am particularly confident about the ETF for 2023 and 2024, thanks to an increase in military spending in the NATO area and an improvement in the global supply chain that will lead to higher returns for companies in the sector. On the other hand, the ETF is highly correlated and very sensitive to S&P500 downturns, so we might expect not-so-brilliant performances in the next 2 or 3 months.

The fundamentals will drive the price in 2023

The defense sector is certainly one of the most interesting at the moment and one of the most interesting in the coming years as well. With defense spending on the rise around the world and mainly thanks to the rearmament of NATO nations, DFEN has excellent opportunities for its companies to perform very well in the year ahead.

In particular, there are many news reports and press releases that confirm this vision.

Below I briefly propose some articles that could be useful for readers to learn more about the topic.

Military Spending Surges, Creating New Boom for Arms Makers

The combination of the war in Ukraine and concern about longer-term threats from Russia and China is driving a bipartisan push to increase U.S. capacity to produce weapons.

Source: The New York Times

'Business is very good, unfortunately': Arms fair spotlights bonanza year ahead for weapons companies

Source: CNBC

European defence spending surpasses €200 billion for first time

Source: European Defence Agency

Spending Increase Rounds Off Good Year for Defense Industry. Raytheon, Lockheed Martin Are Rising.

Source: Barron's

I also attach my latest article on Leonardo Spa (FINMF) ( Leonardo: A Great Long-Term Pick ), an Italian company in the defense sector, in particular the words of CEO Profumo on the European defense budget in the coming years are very interesting. In fact, companies like Lockheed Martin and Raytheon have a large part of their revenue coming from Europe.

Some considerations about the ETF

The ETF had mixed performance in regards to the last few years. In the last year it underperformed the ETF SPY and the ETF ITA (its unleveraged equivalent): the performances were +1.75% for ITA, -11.58% for SPY and -12.99% for DFEN. The chart shows that while the defensive sector performed extremely well relative to the benchmark, the leveraged ETF performed very poorly.

Looking at the chart of the last 6 months instead we notice a different trend, with DFEN returning +26.35% (against +1.28% of the SPY), double compared to ITA.

It should be noted that despite the very positive performance of companies in the defensive sector over the past 3 years, DFEN has performed poorly during periods of high volatility or uncertainty. In other words, when SPY performs poorly, ITA tends to perform slightly well, while DFEN performs the worst of all.

Indeed, it should be remembered that when investing in a leveraged ETF, this applies to both gains and losses.

As can be seen from the chart above, DFEN's performance is highly dependent on volatility. Comparing the ETF's performance with that of the VIX (bottom panel), it can be observed that the worst lows were when the VIX was above 30, specifically in November 2020, December 2021, between April and July 2022, and in September 2022.

Therefore, the ETF's position depends on two factors: the outperformance or underperformance of the defensive sector and the general market volatility. As highlighted above, I am personally very bullish on the industry's performance over the next few years. However, I am not so sure that volatility will normalize in the coming months.

In fact, I believe that due to the problems caused by the bankruptcy of Silicon Valley Bank and the issues in Europe related to Credit Suisse, the market could experience negative performance, as has been the case recently. Furthermore, the increase in interest rates and the market's dependence on economic data for a possible pivot will be sources of stress for the stock markets in the coming months.

The risks associated with this leveraged ETF

Leveraged ETFs have gained popularity among investors seeking amplified returns. However, these instruments carry inherent risks that warrant caution. Indeed, specifically designed for short to medium-term tactical investment strategies, leveraged ETFs can exhibit value erosion when held over extended periods, making them unsuitable for long-term portfolios. Due to the daily resetting feature, these funds tend to underperform their underlying indices in volatile markets, leading to potential losses for investors.

Both the ETF sponsor, Direxion, and regulatory authorities like FINRA and the SEC have issued warnings about the risks associated with leveraged ETFs. So, the investors should understand the characteristics and potential pitfalls before investing in these products.

Conclusion

Nobody knows for sure what to expect from the market, especially in such an uncertain environment. However, my view is that the volatility will continue, but given that I have a more medium term view, I am sure that DFEN's performance will be driven mainly by corporate fundamentals and therefore I am convinced that the ETF will perform well in 2023. So while there may be some jolts on the horizon, I give the ETF a "Buy" rating.

Note: if you have a bullish view on the defence sector, but you are concerned about the volatility, a better pick could be the ETF ITA .

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