Can Defense Investing be ESG?

Geopolitical risks are intensifying around the world. China’s recent military exercises around Taiwan and reports of North Korean soldiers joining Russia’s war effort Ukraine are just the latest news items that reflect the growing potential for conflict, economic disruptions, and instability.

The rise in geopolitical tensions is mirrored by a surge in global military spending. According to the Stockholm International Peace Research Institute (SIPRI), global defense expenditures reached a record high of over $2.43 trillion in 2023, reflecting a growing prioritization of security by nations across the world. This rapid growth in defense spending marks the beginning of what many are calling a new defense supercycle, characterized by sustained investment in military capabilities.

As defense budgets expand, investor interest in the sector is also rising. This reflects a marked difference from previous years. In the lead-up to Russia’s invasion of Ukraine, it was widely reported that Environmental, Social, and Governance (ESG) investing was placing increasing pressure on defense stocks. As ESG-focused funds attracted significant capital, defense companies were often excluded, similar to the way tobacco and coal firms have been treated by socially conscious investors.

However, the landscape has shifted significantly since the start of the Ukraine conflict. The previously rigid stance against defense stocks has softened. Just weeks after the war began, Swedish bank, SEB, reversed its position, allowing some of its funds to invest in defense companies—less than a year after initially excluding them.

Similarly, PensionDanmark announced investments in naval patrol ships, citing "a shift in the general perception of defense investments" following the invasion of Ukraine. Meanwhile, the UK’s Investment Association, in collaboration with the Treasury, declared that defense stocks could be aligned with ESG considerations.

As Dirk Winkels from Rheinmetall noted on a recent webinar with HANetf, “We are seeing the reputation and perception of the defense industry has changed significantly since the war, and people are understanding that – to even think about ESG – you need a basis, which is safety and peace in our society.”

This evolving sentiment is also reflected in recent survey results. As part of HANetf’s Thematic & Digital Assets Review, 50 wealth managers across Europe were asked if defense investing could be compatible with ESG principles. Over 90% responded affirmatively.

The European Union’s recent Defense Industrial Strategy further highlights this shift in perception. The strategy acknowledges the defense sector’s vital role in ensuring Europe’s security and emphasises the need to finance the rebuilding of Europe’s defense capabilities and supply chains. This signals growing acceptance of the sector among investors.

The Rise of Defense-Focused ETFs

As more investors look to gain exposure to defense, many are choosing exchange-traded funds (ETFs) that offer diversified access to the theme. Rather than investing directly in individual stocks, these ETFs provide a broader approach to defense-related industries. Defense ETFs in Europe have taking around $1.5bn in inflows this year alone, according to data from TrackInsight. 

But how can defense-focused ETFs be designed to meet ESG criteria? After all, ESG strategies are fundamentally about managing risk by avoiding or underweighting companies considered to pose higher risks in areas like environmental impact, social responsibility, and governance. 

Only NATO-domiciled companies?

One method to align defense investments with ESG principles is to adopt a more tailored screening process. For example, ensuring that only companies headquartered in NATO or NATO+ countries are invested in. The rationale is twofold: it captures the expected increase in NATO defense spending, particularly in Europe, while also mitigating risks related to geopolitical exposure.

ESG strategies traditionally focus on managing non-financial risks, such as carbon emissions or supply chain vulnerabilities. However, when it comes to defense, traditional ESG screens often overlook the critical factor of geopolitical risk. One of the biggest threats for investors is being exposed to companies supplying arms to nations that may one day become adversaries. Restricting defense exposure only to firms domiciled within NATO or NATO+ allies potentially provides mitigation against that risk. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.