ESG and defence investing: a balancing act

ESG investors warm to defence

In the months preceding Russia’s invasion of Ukraine, the Financial Times highlighted a trend where the rise of ESG (Environmental, Social, and Governance) investing exerted pressure on European defence stocks. As ESG funds attracted more capital, defence sector firms found themselves increasingly shunned, reminiscent of the treatment meted out to tobacco and coal companies.

Consequently, a noticeable valuation gap began to emerge between European defence companies and the broader MSCI Europe Index. Likewise, US defence stocks traded at higher multiples compared to their European counterparts, reflecting the two region’s divergence on ESG consideration.

How times change. Since the outbreak of the war in Ukraine, there has been a rethink about this automatic prohibition on defence sector stocks. Less than a month after the war started, Swedish bank SEB announced some of its funds would be able to hold defence companies, a reversal of a position it had adopted less than a year prior.

However, the outbreak of the war in Ukraine prompted a re-evaluation of the automatic exclusion of defence sector stocks from investment portfolios. Within a month of the conflict’s onset, Swedish bank SEB announced a significant policy reversal, permitting some of its funds to hold defence companies—a stark departure from its position less than a year prior.

Moreover, recent data from Morningstar indicates a shifting tide, with growing acceptance of defence stocks in ESG-labelled funds. By the end of the third quarter of 2023, over 1200 ESG funds included stocks from the Aerospace & Defense sector—a 25% increase from March 2022. Surprisingly, a YouGov poll cited by analysts from Citi Group showed that defence stocks faced less negativity from an ESG perspective compared to sectors traditionally considered more aligned less in tension with ESG principles, such as luxury fashion, banking, and media.

The European Union’s recognition of the pivotal role played by Europe’s defence sector in safeguarding the continent’s security further underscores the changing sentiment. The European Defense Industrial Strategy, recently announced, emphasises the necessity of financing the rebuild of Europe’s defence sector and supply chains, hinting at a potential momentum towards greater acceptance of defence stocks.

Rise of defence ETFs

Investors are exploring avenues to integrate defence exposure into their portfolios. While some opt for direct investment in individual stocks, an increasing number are turning to exchange-traded funds (ETFs) that offer diversified exposure to the defence theme. Notably, defence-focused ETFs listed in Europe have amassed nearly $900bn in assets under management since the beginning of 2023—an impressive feat considering the absence of such funds in Europe just a year prior.

How can defence-focused ETFs be made to ensure they are more appealing from an ESG perspective? Afterall, the basic proposition behind ESG approaches is risk mitigation. That is, excluding or underweighting stocks deemed to pose higher material risk on the basis of each of the three letters. For investors looking for defence exposure, such principles still apply.

Using a NATO+ screen for responsible exposure  

One approach adopted by the EQM Future of Defence Index involves employing two distinct screens. Firstly, a standard ESG-type screen is used to exclude firms not compliant with the United Nations Global Compact (UNGC) principles and Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises, thus addressing risks related to labour rights, human rights, taxation, and corruption practices.

More uniquely, though, the index employs its NATO screen. Companies considered for addition to the index must be headquartered in NATO+ countries. Part of the reason for this screen is to provide exposure to the expected growth of NATO defence spending, particularly among European NATO members. But the screens also attempt to provide risk mitigation in the same way classic ESG screens do. Chiefly, by ensuring on NATO+ headquartered firms are included, the potential exposure to geopolitically irresponsible actors is reduced. With this screen, the index will not include exposure to the weapons suppliers of nations that may act in a hostile manner to the USA or European.

The other consideration is that NATO’s rationale as a military alliance is defensive. That is, to prevent the resumption of large-scale war on the continent and safeguard European members from invasion through collective alliance.

Narrowing the investment opportunity and lost performance

Another approach, lending from many ESG screens, is to exclude companies deriving revenue from the sale of so-called “controversial weapons”.

However, the implementation of exclusionary screens, such as those barring companies deriving revenue from controversial weapons, poses challenges. Notable defence names like RTX and BAE Systems may be excluded, raising concerns about the index’s deviation from the core defence market and its impact on performance. Indeed, since July 4th, 2024, the EQM Future of Defence Index has delivered a return of 39%, with almost 8% of that performance attributed to these three names. The absence of such core components of the defence sector could significantly affect index performance.

Striking a balance between ESG screening and optimal defence exposure is imperative. As investors navigate this increasingly popular sector, the challenge lies in ensuring that defence-focused ETFs not only adhere to ESG principles but also provide effective risk mitigation strategies while capturing the growth potential of the defence industry. The use of UNGC and OECD Guidelines screens mitigates certain ESG-related risks, while the NATO+ screen addresses unique risks inherent in investing in the defence sector.

Written by: Tom Bailey – Head of Research at HANetf