Top-5 defence sector: leaders exposed to moral risk

Investing in weapons and the military industry is controversial for many investors. For example, since 2011, investing in companies that produce, sell or distribute cluster munitions or crucial components thereof has been prohibited by law in 110 countries, including the Benelux. 

It is important to note however that the legal prohibition does not apply to participation in investment institutions and indices in which the producers of cluster munitions or companies involved represent less than 5 percent of the value of that investment institution or index.

Not every asset manager was ready for that. That was made clear a decade ago, then the introduction of the ban forced Franklin Templeton out at ABN Amro. With the rise of responsible investment, the ban on cluster munitions has evolved into a broader exclusion of the arms industry by institutional investors. 

Controversial weapons excluded

Weapons that cause disproportionate suffering, are unreliable and inaccurate, and make no distinction between military targets and civilian victims, are excluded by an increasing number of investors under the heading of controversial weapons. This means that, for example, companies active in the production of nuclear weapons, biological weapons, chemical weapons, anti-personnel mines, white phosphorus and depleted uranium, as well as producers of cluster munitions, are excluded from the investable universe.

In concrete terms, this policy means that companies such as South Korea’s defence company LIG Nex1 Co Ltd, which is involved in the production of cluster bombs, have been placed on the cluster bomb list by the Dutch supervisor AFM and therefore are off limits. Depending on the sustainability criteria used by fund houses, other companies such as Lockheed Martin, the world’s largest defence company that provides the US army with aircraft, navy ships, land forces vehicles and missiles, and its British counterpart BAE Systems, may not be investable. 

Stricter sustainability standards could also lead to the exclusion of arms manufacturers such as Smith & Wesson, or companies for which military procurement accounts for a significant proportion of turnover, such as General Electric or Rheinmetall. 

Digital defence seen as legitimate

The defence industry however has not completely disappeared from the radar of investors, but has changed over time. With the rise of the internet and far-reaching digitalisation, the importance of cyber security has grown exponentially. As a result, digital defence is more prominent on the agenda, making it the last legitimate investment in the defence sector.

Although the exclusion of various defence industries has become commonplace, the debate on the investability of the defence sector has recently flared up again as a result of the Russian invasion of Ukraine. With European governments sharply increasing their investments in national and international defence, interest groups are lobbying to be freed from the negative stigma the industry carries. 

SEB Investment Management, the asset management arm of Sweden’s SEB, has reviewed its strict exclusion policy for the defence sector and, in response to growing geopolitical tensions, has decided to broaden the scope of some investment funds’ investments in the sector. The asset manager argues that investments in the defence industry are essential for the maintenance and defence of democracy, freedom, stability and human rights. This is in line with the German defence and security industry lobby group BDSV’s call to the EU to recognise the defence industry’s positive contribution to social sustainability under the ESG taxonomy. This could be the next controversial step after temporarily labelling gas and nuclear energy as sustainable.

Mixed exposures in some global large-cap funds

When we rank the mutual funds and ETFs in the Morningstar global large-cap equity category mixed on their exposure to companies that are both directly and indirectly involved in procurements related to military weapons, weapons systems, secondary components of weapons, or weapons-related services, JO Hambro Capital Management Global Opportunities Offshore scores the highest. Positions in L3Harris Technologies Inc and Thales give the fund an allocation of nearly 7 percent to the defence sector. A year ago, the fund also invested in Northrop Grumman, one of the world’s largest defence companies, while Raytheon Technologies and Safran were also previously part of the portfolio, giving it more than 10 percent exposure to the defence sector.

Maj Invest Global Value Equities follows in second place with positions in Parker Hannifin and MTU Aero Engines, while the highly diversified Wellington Downside Alpha Opportunities invests in 16 companies with exposure to the defence sector, including Raytheon Technologies, BWX Technologies and General Dynamics.

Top 5 performers (classification for the Netherlands)

Top 5 performers (classification for Belgium)

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