As geopolitical tensions escalate and global defence spending increases, a growing number of investors are turning to defence-focused exchange-traded funds (ETFs). These funds not only provide a hedge against uncertainty but also present opportunities for capital growth.
“We are seeing clients buy the Nato ETF as a hedge against geopolitical risk,” said Tom Bailey, head of research at HanETF, which last year launched a defence-ETF with ticker code ‘Nato’. “Whereas some investors use gold or bonds as a hedge against such risk - a so-called flight-to-safety, we see growing appeal among clients to use the Nato ETF in the same way. The ETF captures the so-called flight-to-arms trade that happens in the face of geopolitical shocks. Therefore, many see it as a tool for hedging geopolitical risk.”
The current geopolitical climate, marked by rising tensions worldwide, appears to support increased exposure to defence. Global defence spending rose by 9 percent in 2023, reaching a record $2.2 trillion. This trend is reflected in the developments within the ETF market.
Also see: The Military Balance, IISS
VanEck’s Defence ETF recently surpassed the $1 billion mark in assets under management (AUM), driven in part by rising global military expenditures. Launched in 2023, the fund reached $100 million in AUM just seven months after its inception and continued to grow, hitting $500 million by April this year.
HanETF has also seen significant growth, with around $379 million in new inflows into its Nato ETF since the beginning of the year, bringing its total AUM to approximately $467 million.
Amid growing instability on the geopolitical stage and a sharp increase in defence spending by Western countries, pure-play defence ETFs are well-positioned to benefit from these trends. Investors are now seeing significant opportunities in the stocks of companies operating within the security and defence sectors. This sentiment has driven a notable rise in the share prices of defence companies.
A new safe haven
The growing interest in defence ETFs reflects a shift in how investors approach risk management. Traditionally, gold and bonds have been the go-to safe havens during times of uncertainty, but the recent “flight to arms” trend has positioned defence ETFs as a new form of protection.
This shift is exemplified by HanETF’s Future of Defence ETF and the iShares Global Aerospace & Defence ETF, traded under the ticker ‘DFND’, both launched shortly after VanEck’s offering. Martijn Rozemuller, CEO of VanEck Europe, notes that the war in Ukraine has led many investors to see potential in the stocks of companies within the defence and security sectors, further contributing to the popularity of these funds.
“The largest conflict in Europe in the last decades was an eye-opening event for politicians and individuals in Western Europe,” Rozemuller told Investment Officer. ‘After many years of enjoying the peace dividend, members of Nato are again committing to the two percent of GDP spending target. 23 out of 32 member states have already reached this target, with Germany, the Netherlands, Norway, and Turkey fulfilling this target for the first time.”
“It seems that defensive capabilities have been underestimated for a while. The current geopolitical situation underscores the need for innovation and modernization in the defence sector. Consequently, we would not be surprised if this is going be a long-term trend from which defence companies could benefit.”
Reassessment
While there are compelling financial arguments for investing in defence ETFs, ethical considerations remain a point of contention, particularly in the context of the ESG debate. The war in Ukraine has prompted many investors to reassess their stance on defence stocks. Some institutions that previously excluded investments in this sector are now reconsidering their positions.
“The ethical question is always a very individual one,” said Christophe Mellor of the ETF equity product management team at Invesco. “It appears that, at least for some investors, we have seen a reevaluation as the importance of defence investment, in protecting the rule of law and the freedom of democracy, has been driven home by the invasion of Ukraine.”
To mitigate ethical concerns, HANetf now applies a so-called ‘Nato screening’ for its ETF, which means that only companies from Nato+ countries are included in the fund.
“It appears that, at least for some investors, there has been a reassessment of the importance of investing in defence.”
“When it comes to defence, traditional ESG screens fail to incorporate the most important “non-financial metric” - geopolitical exposure/risk,” said Bailey at HanETF. “The biggest risk is finding yourself exposed to companies producing arms for potential rival countries we may one day face hostilities with or may act in a geopolitically aggressive way. So, rather than only opt for a traditional ESG screen, we’ve used a geopolitical screen - the Nato screen.”
Martijn Rozemuller of VanEck does not necessarily see defence as being in conflict with ESG principles. “We believe that the defence industry is not necessarily antonymous to ESG. While there are definitely companies with questionable practices, we believe that the industry as a whole is a vital part of any country’s existence.
Risks
While interest in defence ETFs is increasing, there are also risks involved. Investments like these require careful consideration of both potential benefits and drawbacks. As both Invesco and Van Eck point out, investors need to think carefully about the long-term impact of these investments.
“All thematic funds need to manage concentration and liquidity risks appropriately,” said Mellor. “However, an investor in any thematic should be aware that they may be taking on a very clear sector biases in such an investment. There are a number of ways to moderate this risk, investing in a portfolio of thematics that offer different potential drivers of long-term performance, or holding a core broad equity exposure and coupling it with a thematic satellite investment are two potential approaches.”
“Currently, the ETF provides exposure to key players while excluding companies involved in controversial events or the production of controversial weapons. Please mind the risks, including the equity market risk and industry or sector concentration risk,” said Rozemuller.
Mellor added: “ The next question is whether you can get meaningful exposure to the theme, in the case of defence this looks relatively straightforward with a wide range of pure-play companies in the space, however an investor may look to focus in on specific areas or subthemes that they expect to see the strongest growth.”