Sentiment around defence stocks appears to be on the upswing. Numerous investors previously avoided such investments, yet deglobalisation and geopolitical unrest have made the case for investing in defence more tenable.
Politically, there is an increasing clamour for a resurgence in defence spending following years of austerity, spurred by global tensions. This year, the defence budget of the Netherlands has seen a significant boost to 21 billion euros, edging our nation closer to meeting the NATO standard for the first time. This benchmark mandates member states to allocate 2 per cent of their gross domestic product towards defence. Furthermore, discussions continue around the establishment of a European army.
Price surge
There’s a noticeable uptick in investor interest towards defence equities. Rheinmetall, a constituent of Germany’s premier DAX index, experienced a stock market surge of over 90 per cent within a year. Early this month, it was revealed that the German arms manufacturer achieved record figures in 2023, propelled by the conflict in Ukraine. Projections for the ongoing financial year remain positive. Meanwhile, Palantir Technologies, a US firm providing software solutions to Ukraine, among others, saw its stock value soar by more than 200 per cent during the same timeframe.
“We observe an increasing demand for defence investments from end customers,” said Renco van Schie, CIO and partner at asset management firm Valuedge. “They are confronting an unsafe world marked by conflict and insufficient defence spending.”
“The assumption was that the conflict in Ukraine would eventually conclude, yet now a second conflict has emerged, with the initial one still unresolved. These developments aren’t fading into the background anytime soon. This kindles interest, particularly from private investors feeling personally insecure.”
Valuedge has placed its bets on a defence and a cybersecurity ETF. “This allows us to tweak the exposure should the performance of either ETF begin to diverge markedly. Cybersecurity remains subject to hype, with valuations soaring. This concern is less pronounced with pure defence firms.”
As governments incrementally increase their defence investments, defence companies are witnessing a rise in profits. “A substantial flow of funds is moving from nations to a select few companies. We’re merely at the start of a profit explosion for such entities.”
According to Van Schie, the allure of defence stocks isn’t solely based on financial returns. “For a while, sustainability was a priority for investors, but particularly in the US, there’s a shift away from ESG considerations, partly due to vague sustainability criteria and the recent underperformance of sustainable investment strategies.”
Early adopters
Although Valuedge notes a surge in interest, the firm acknowledges that not many have yet ventured into defence investing. “Those who have are truly pioneers. Yet, many institutional entities remain distant.”
Moreover, the opportunities for investing in the defence sector via a fund remain scarce, observes Jeffrey Schumacher, director of manager research at Morningstar. Many funds incorporating specific sustainability criteria often exclude defence stocks. “There are hardly any funds dedicated solely to the defence sector. The exposure to defence entities, primarily due to sustainability exclusions, is rather limited.”
Emergence of defence ETFs
The challenge for traditional funds is the advent of defence ETFs. A variety of these index trackers have hit the market in the past year, including VanEck’s Defense ETF and the more recent iShares’ Global Aerospace & Defence ETF.
Currently, VanEck’s ETF holds approximately 400 million euro. Martijn Rozemuller, VanEck’s CEO in Europe, described it as the fastest-growing ETF launched by VanEck in Europe.
Nonetheless, Rozemuller admits to initial reservations about introducing the defence ETF. “Particularly from retail investors, driven in part by Russia’s invasion of Ukraine, there was a growing call for such an ETF. Initially, we were hesitant. Given the prevailing ESG trend, investing in arms suppliers is not the norm. However, as European governments sought to aid Ukraine with weapon supplies, they discovered stock shortages and outdated equipment, after years of defence underfunding. Hence, we considered that investing in defence was, in fact, justifiable,” Rozemuller explains.
Cluster bombs shunned
“A nation ought to possess the means for self-defence.” He contended that distinguishing between offensive and defensive weaponry is challenging. The decision was ultimately made to exclude controversial arms. Valuedge similarly shuns controversial weaponry, such as cluster bombs. “The remainder is justifiable,” Van Schie said.
Rozemuller: “We still don’t claim to invest solely in the defence industry, but we’ve endeavoured to rule out contentious issues. This isn’t particularly challenging; the data exists. Ironically, I’m more frequently queried about the absence of a specific stock from the ETF than about its inclusion. This reflects the mindset of those considering defence investments.”
Resistance among institutional investors
Rozemuller still observes reluctance among large institutional entities and pension funds towards defence investing. He said he anticipates this stance will shift for various parties. “To your supporters, you can no longer justify not investing in defence.”
Rozemuller lacks a precise breakdown of the investors in the defence ETF but suspects a significant portion are retail investors. “Perhaps half.”
He is also convinced that many smaller independent asset managers have invested in the ETF, with some larger entities leaning towards institutional investment. “You don’t amass invested assets of four hundred million euros with retail money alone. This indicates that a considerable amount of professional investment has also flowed into the ETF.”
According to Van Schie, institutional investors seem to be awakening, especially following recent remarks by the outgoing Defence Minister Ollongren. She suggested that by abstaining from weapons investment, pension funds had become “part of the problem”. “That assertion might be overstating it, especially since pension funds are generally prohibited from weapons investments,” Van Schie said. “However, signals from The Hague and the market suggest the criteria for pension investments are becoming more flexible. It’s likely that work is underway behind the scenes to adjust these criteria.”
Customer wishes
VanEck’s Rozemuller said pension investors should reconsider whether their investment strategies align with their clients’ desires, particularly regarding defence investments. “Conducting a survey among participants every month to assess investment policy might not be feasible, but given the strong societal and political demand, exploring interest in defence investments isn’t unreasonable. Such a survey’s findings could provide a clear rationale to Ollongren for either supporting or opposing defence investments. After all, the pension sector should offer her a response.”
In response to Ollongren’s call, ASR Vermogensbeheer is one entity that has reviewed its stance. While acknowledging a shift in sentiment towards defence investments, ASR, after a thorough examination, found no compelling reason to directly invest in commercial arms companies or arms traders. “We recognise the necessity for weapons to protect national borders and deter attacks on countries,” ASR remarked last year. “Yet, this is counterbalanced by the dilemma of financing the arms industry while ensuring respect for human rights and avoiding innocent civilian casualties should weapons fall into the wrong hands. As investors in the arms industry, we cannot guarantee that weapons are used solely for justifiable ends, such as defending freedom and democracy and upholding the rule of law.”
Supporting democracies
However, ASR continues to indirectly invest in defence through its support for democratic governments. “This approach aims to prevent our policyholders’ funds from being misused.” ASR remains open to alternative investment avenues, like a bond issued by the Dutch government for defence purposes.
Thus, while private investors are increasingly drawn to defence investments, institutional entities have remained cautious. Nonetheless, with Ollongren’s urging for pension funds to engage, a shift in sentiment among professional investors appears imminent. “Everything suggests that a movement is underway,” Van Schie said.
Further reading on Investment Officer Luxembourg:
- Defence investments dilemma is tough test for ESG
- Belgium sees growing support for ‘common defence bonds’
- Top-5 defence sector: leaders exposed to moral risk