Originally published at: Can defence investing be ESG? – InvestEngine Insights
In the months preceding Russia’s invasion of Ukraine, the Financial Times highlighted a trend where the rise of ESG (Environmental, Social, and Governance) investing exerted pressure on European defence stocks. As ESG funds attracted more capital, defence sector firms found themselves increasingly shunned, reminiscent of the treatment meted out to tobacco and coal companies.
Consequently, a noticeable valuation gap began to emerge between European defence companies and the broader MSCI Europe Index. Likewise, US defence stocks traded at higher multiples compared to their European counterparts, reflecting the two region’s divergence on ESG consideration.
Investors warm to defence
How times change. Since the outbreak of the war in Ukraine, there has been a rethink about this automatic prohibition on defence sector stocks. Less than a month after the war started, Swedish bank SEB announced some of its funds would be able to hold defence companies, a reversal of a position it had adopted less than a year prior.
We’ve also seen PensionDanmark announce their investment in naval patrol ships. A spokesperson from the pension fund noted “a shift in the general perception of defence investments after Russia’s invasion of Ukraine.” At the same time, the UK’s Investment Association issued a joint statement with the UK Treasury arguing that defence stocks are “compatible with ESG considerations”.
The European Union’s recognition of the pivotal role played by Europe’s defence sector in safeguarding the continent’s security further underscores the changing sentiment. The European Defense Industrial Strategy, recently announced, emphasises the necessity of financing the rebuild of Europe’s defence sector and supply chains, hinting at a potential momentum towards greater acceptance of defence stocks.
Rise of defence ETFs
Investors are exploring avenues to integrate defence exposure into their portfolios. While some opt for direct investment in individual stocks, an increasing number are turning to exchange-traded funds (ETFs) that offer diversified exposure to the defence theme.
How can defence-focused ETFs be made to ensure they are more appealing from an ESG perspective?
After all, the basic proposition behind ESG approaches is risk mitigation. That is, excluding or underweighting stocks deemed to pose higher material risk on the basis of each of the three letters. For investors looking for defence exposure, such principles still apply.
Using a NATO+ screen for responsible exposure
One approach adopted by the Future of Defence UCITS ETF (NATO) involves employing two distinct screens. Firstly, a standard ESG-type screen is used to exclude firms not compliant with the United Nations Global Compact (UNGC) principles and Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises, thus addressing risks related to labour rights, human rights, taxation, and corruption practices.
More uniquely, though, the index employs its NATO screen. Companies considered for addition to the index must be headquartered in NATO+ countries. Part of the reason for this screen is to provide exposure to the expected growth of NATO defence spending, particularly among European NATO members. But the screens also attempt to provide risk mitigation in the same way classic ESG screens do.
As I noted, ESG is about “risk mitigation”. It is a tool to incorporate non-financial metrics that may pose a risk to securities such as high carbon emissions or supply chains management.
When it comes to defence, traditional ESG screens fail to incorporate the most important “non-financial metric” – geopolitical exposure/risk. 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.
Future of Defence UCITS ETF (NATO) provides exposure to the companies generating revenue from NATO and NATO+ ally defence and cyber defence spending.
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