With an evolved approach to military spending, globally and Europe-wide, investors are not shying away from investing in defence-themed funds, finds Piyasi Mitra.
In April, UK Prime Minister Rishi Sunak announced plans to increase the UK’s defence spending to 2.5% of GDP by 2030. The UK’s defence spending boost appears to be part of a broader global trend. Recently, Nato Secretary General Jens Stoltenberg reported unprecedented defence spending increases across European allies and Canada. This raises the question: what factors are suddenly driving the surge in investment in defence-themed funds?
“Insensitivity” is key
The post-Cold War ‘peace dividend’ days are behind us in a world of mounting geopolitical risks, points out Jason Hollands, managing director at online investing platform Bestinvest. European Nato members, recognising that they cannot solely rely on the US for their security, are significantly increasing military budgets.
This trend extends beyond Europe, with Australia investing heavily in defence through the AUKUS partnership, a lucrative deal for UK aerospace and defence firms BAE Systems and Rolls-Royce, Hollands says.
The investment case for owning aerospace and defence companies is not solely about the UK’s commitment to increase spending, but a wider global pattern. According to Hollands: “One feature of defence order books is that they are multi-year in nature and therefore relatively insensitive to the economic cycle, which makes defence ‘defensive’ from an investment perspective in uncertain economic times.”
It is also noteworthy that HM Treasury in tandem with investment industry body the Investment Association put out a note alongside the defence spending announcement to assuage the doubts of those with an ESG outlook. It said: “Investing in defence companies contributes to our national security, defends the civil liberties we all enjoy […] and is compatible with ESG considerations as long-term sustainable investment is about helping all sectors and all companies in the economy succeed.”
“One feature of defence order books is that they are multi-year in nature and therefore relatively insensitive to the economic cycle, which makes defence ‘defensive’.” – Jason Hollands, MD, Bestinvest
The high-tech nature of modern armaments and guidance systems involves multiple firms benefiting a broad range of suppliers. Since the Russia-Ukraine war, the MSCI World Aerospace & Defence Index has outperformed, delivering a total return of 40% in US dollars, compared to the MSCI All Country World Index’s 17%, points out Hollands.
“Direct shares in leading players like Rolls-Royce, which saw a 170% increase in shares over the past year, or through active fund managers with significant exposure to aerospace and defence, present opportunities.”
Rising UK defence spending could bolster the domestic defence sector, creating jobs and potentially lifting the UK stock market, he adds. Aerospace and defence stocks make up about 3.8% of the FTSE 100 and 3.4% of the wider UK market, compared to 1.5% of the S&P 500, indicating a high market weighting for the UK.
Another option is to invest in an ETF that tracks a basket of leading aerospace and defence companies, says Hollands, as active fund managers also have significant exposure to this sector. He cites that the Ninety One UK Special Situations fund holds 9.3% in Rolls-Royce, JP Morgan Claverhouse investment trust holds 8.8% (including BAE and Rolls-Royce) and Law Debenture IT holds 8.5% (with Rolls-Royce as the top holding), at the time of writing.
“Rise of tension”
In agreement with Hollands, Pierre Debru, head of quantitative research and multi-asset solutions at WisdomTree, underscores that the EU member states have notably increased military spending, rising from €240 billion in 2022 to €280 billion in 2023, and it is projected to hit €350 billion in 2024, marking a 25% increase, according to WisdomTree’s Thematic Monthly Update, April 2024.
“These developments have benefited defence companies and are reflected in the ‘rise of tension’ theme,” says Debru. European thematic funds focusing on defence have shown a year-to-date return of 17% and a trailing 12-month return of 50.3%, making it the best-performing theme this year. These funds have also gathered $712 million in the year to date, second only to AI and big data, cites Debru.
“Investing in defence companies contributes to our national security, defends the civil liberties we all enjoy […] and is compatible with ESG considerations.”-Hollands
Figures from different sources paint a similar picture. Significant growth in assets under management has come from increased investor interest in defence and uranium, reports ETF provider HANetf, whose Nato Future of Defence ETF provides exposure to Nato defence spending and has accrued $383.85 million so far. The ETF provider attributes this to the Russia-Ukraine conflict and trade sanctions creating a market gap.
Other European countries are no exception. For instance, France has struck major deals for Dassault Aviation’s Rafale fighter jet with Qatar, Egypt and India. Similarly, Italy’s arms exports have also surged by 86% over the past three years, and overall, European countries nearly doubled their arms imports between 2014-2018 and 2019-2023.
“Geopolitical unrest is worsening. More and more munitions are being diverted to these conflicts, depleting stockpiles and necessitating further spending,” says HANetf.
The EQM Future of Defence Index highlights this potential. Companies in this index must derive over 50% of their revenues from military aircraft, defence equipment, defence technology or cybersecurity contracts with a Nato member. The index avoids overconcentration with a single stock cap of 5% and a single country cap of 60%, boosting allocation to European defence names. As of the time of writing, approximately a third of the index’s holdings are domiciled in Europe, cites the ETF provider.
Successful examples include Thales, up 16.60% year-to-date, with a 15-year £1.8 billion contract with the UK Ministry of Defence. Safran is up 28.81% year-to-date, securing contracts with the UK Ministry of Defence and Royal Air Maroc. Rheinmetall, a German arms manufacturer, has forecast record sales of €10 billion for 2024. BAE Systems, a British aerospace and defence company, has seen a 120% share price gain since Russia invaded Ukraine, with multiple orders, including a $754 million contract from the US Army.
Changing sentiment
The perspective towards defence investment is shifting. As people recognise the importance of security, investing in defence is being seen as “less of a problem”, says Martijn Rozemuller, CEO of asset manager VanEck EU.
Recently, the European Defence Industrial Strategy, aiming to increase European defence industrial readiness through collaborative EU-based investment, research, development, production, procurement and ownership, has been put forward to set a clear, long-term vision to achieve defence industrial readiness in the EU.
Long-term geopolitical tensions could arise from US-China competition, Russia-Nato conflicts, cyber-attacks, and climate risks, presenting investment needs for companies that provide defence solutions for these challenges, says Rozemuller.
However, with more funds entering the defence sector, asset managers should diversify investments across segments and consider concentration risks from companies reliant on a few clients.
“Given the sensitive nature of investing in military and weapons, it makes sense for asset managers to consider integrating the prevention of controversies into their investment strategies.”-Martijn Rozemuller, CEO, VanEck EU
“Given the sensitive nature of investing in military and weapons, it makes sense for asset managers to consider integrating the prevention of controversies into their investment strategies. Examples are screens to prevent investing in companies related to violations of international standards or companies involved in controversial weapon production,” says Rozemuller.
Increased R&D budgets in the defence sector are crucial, he adds. Investors are prioritising companies with strong R&D capabilities, as these firms are likely to develop innovative solutions, including services and software initiatives, that meet evolving defence needs and capture market share.
Beyond the battlefield, cybersecurity and defence appear correlated, even in the investment space. According to Rozemuller: “The defence sector, traditionally hardware-centric, is now focusing more on software and cybersecurity. This shift not only enhances defence capabilities but also attracts investments in new defence sub-industries like cyber warfare.”
Debru agrees, emphasising that beyond defence, geopolitical tensions are also boosting the theme of cybersecurity. “Increased investment in cybersecurity by states and corporations aims to counter rising cyber threats, especially those amplified by AI.”
Private investors, after deciding to invest in a particular sector, are faced with the daunting task of picking the right stocks to invest in. VanEck’s Defense Ucits ETF aims to alleviate this problem by providing transparent and “pure-play” exposure to the defence sector using an index strategy. Rozemuller shares that to diversify, the ETF invests in at least 25 stocks and applies a “controversy and controversial weapons screen” to prevent investments in so-called “bad actors” within the defence industry.
With controversies subsiding, defence is gaining a fillip as a hot investment theme. Nato’s recent announcement that 18 of the 31 alliance members will hit the 2% GDP defence spending target this year signals strong growth ahead for the sector. As geopolitical tensions continue to shape global security needs, the defence sector offers promising opportunities for investors looking to balance financial returns with strategic importance.
