Is there ever a case for defence stocks in sustainable funds?

Ask many people to name half a dozen sectors that should never find their way into a sustainability-themed or ESG (environmental, social, governance) focused fund, and the chances are that armaments manufacturers will be high on the list, alongside the likes of tobacco, oil and coal.

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Defence stocks have been excluded from such portfolios since the UK’s first ethical funds, the Stewardship funds managed by Friends Provident, were launched back in 1984. These funds were largely designed by Quakers and Methodists opposed to any involvement in war, and so it was a no-brainer to screen out arms manufacturers from their investment universe.

In the US, the link between the emergence of ethical investment vehicles was even more stark: the Pax Fund was launched in 1971 as a direct reaction to public outcry at the atrocities of the Vietnam War. 

As Julia Dreblow, founder of the sustainable fund research firm SRI Services, observes, the conflicts may be different today, but the ethical fundamentals remain clear. “Weapons kill people, and there are many investors who want nothing to do with companies that are involved in such activities,” she says.

Environmental implications

There are huge environmental implications too, from massive fuel consumption and CO2 emissions by military vehicles to landscape damage or pollution when industrial, oil or utilities plants are attacked.

“The fact that excluding armaments companies now extends beyond ‘ethical’ investments to socially and environmentally focused ‘sustainability’ funds and the much larger cohort of ESG funds that primarily focus on reducing investment risk also indicates that this is far more than a niche concern,” Dreblow adds.

Divestment from arms companies is further underpinned by the continuing shift among passive investors “from funds providing exposure to traditional broad equity benchmarks to ESG-filtered versions of those funds, many of which include defence screens,” says Stuart Forbes, co-founder of the specialist impact investor Rize ETF.

Russia’s invasion of Ukraine and the international response have to some extent rocked this boat.

Forbes highlights the fact that “following some initial reluctance, countries such as Sweden, Denmark, Finland, Norway, Netherlands, which are some of the countries with the strongest history in ESG investing, have been huge contributors of weaponry and heavy defence machinery.” Sweden and Finland have also joined NATO.

UK government makes case for defence

Against this backdrop, the UK government is increasingly bothered by the fact that even in the face of geopolitical crisis investors continue to blackball defence firms such as BAE Systems (LSE:BA.) and Babcock International Group (LSE:BAB) on the grounds of ESG concerns.

Writing in the Mail on Sunday on 1 August, defence minister James Cartlidge and city minister Andrew Griffiths argue that “peace needs defence, and defence needs an industrial base”, which itself needs to be able to raise funds.

They point out how “perverse” it therefore is that widespread support in the UK for Ukraine’s right to defend itself and live peacefully is accompanied by “a parallel universe where the defence sector is being shunned”.

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But this is not a black and white, ‘good versus bad’ scenario. Dreblow acknowledges that Russia’s aggression certainly means the world feels more dangerous than it used to and elevates the importance of defence capability.

“The bounce in armaments company shares reflects this (BAE shares have risen by over 80% since the invasion started last year) – but it doesn’t make the investment case any easier for funds that have either specifically ruled out armaments involvement or focus on companies with high ESG scores,” she says.

Investors bought those funds because of the way they are run and do not expect a quantum shift in strategy.

Why most sustainable funds avoid defence companies   

It’s a vexed question but not a new one, observes Mike Appleby, manager of the Liontrust Sustainable Future funds, which on ethical grounds have never invested in defence-focused businesses.

“We have heard arguments for sustainable funds investing in weapons companies over the years, along the lines of ‘who arms the peacekeepers’,” he says. But that’s no reason to change Liontrust’s stance. “Some investors do not want to profit from businesses involved in weapons systems and what they are designed to do,” adds Appleby.

Simon Holman, a partner at the sustainably focused financial adviser Castlefield, explains that there are several different angles to the argument against the inclusion of defence stocks in the portfolios he runs.

As well as the human cost and social impact of conflict, Holman points to the often shady politics involved. “The defence industry is inextricably linked to export sales, and that often means the UK government doing deals with nations whose human rights approaches leave a lot to be desired.”

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Saudi Arabia is a prime example, he adds. “Many investors will recall the grisly fate which befell Jamal Khashoggi and feel strongly that they don’t want to invest in companies selling military equipment to such a regime.”

Appleby comments: “We have yet to find a weapons or defence company that only sells to the good guys.”

Even without such behaviour, the industry has a reputation for lack of transparency.

There is also potential for corporate corruption: “It’s a regular bedfellow and one that can lead to material fines that impair shareholders’ capital,” Holman says.

However, his reasons for avoiding defence stocks go beyond those rooted in the moral high ground, to the investment case – the nuts and bolts of stock-picking and the basics of risk-adjusted returns.

Castlefield, like many other active managers, seeks out companies with greater pricing power, higher margins, stronger revenue and profit growth and more manageable debt levels than other alternatives, on the basis that these characteristics underpin a business’s long-term profitability.

“For us, the defence sector doesn’t meet those criteria,” says Holman. Not only are profit margins typically relatively low, but “defence contracts have a history of cost over-runs for the main contractors, again potentially at the expense of shareholder returns,” he notes.

One in four sustainable funds have some exposure to defence

Having said that, many other sustainable/ESG funds operate differently and ‘draw the line’ in different places. Morningstar Direct data shows that 25% of European sustainable funds have some exposure to defence and aerospace stocks, compared with 35% of conventional funds.

Moreover, while 87% of the sustainable fund universe excludes manufacturers of controversial weapons and 59% those of small arms, only a third screen out companies involved in broader ‘military contracting or operations’. That latter category, says Morningstar, “does not necessarily exclude nonmilitary companies involved in materials or components used in controversial weapons”.

So, while funds with very specific exclusion criteria have little scope for manoeuvre, others - most obviously ESG-focused funds – may have more flexibility to adjust their portfolios to some extent to reflect shifts in the public mood.

For instance, says Dreblow: "Involvement in the white phosphorus supply chain, manufacturing cluster bombs and dealing with controversial regimes is likely to remain ruled out by most, but some might back companies with ‘non strategic’ military involvement, such as making safety equipment or supplying products that are customised by the military.”

Those companies in that grey zone might also be able to further their own cause  through “better transparency and engagement with investors and ESG ratings agencies”, she adds.

There are risks attached, though, says Dzmitry Lipski, head of fund research at interactive investor. He points out: “Although fund managers with more flexible mandates that integrate ESG considerations might consider including defence stocks based on defending national interests and freedoms in their portfolios, there’s a danger of ‘greenwashing’ if their inclusion criteria can be changed depending on current priorities.”

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For Appleby too, shifting goalposts is a clear danger for managers. “The most important thing is that sustainable funds are clear about what they will and won’t invest in, so we minimise the risk of surprises in being exposed to controversial business activities,” he explains.

Holman goes further. He argues that it’s not the role of investors to respond to “impassioned calls of duty” to invest in defence stocks, such as that from Cartlidge and Griffiths. While nations do have a right to defend themselves, the industry on which they rely should instead be funded by governments.

“The ministers would do well to understand that a sustainable investment approach is one which considers all the business, environmental, social and governance factors in identifying suitable companies.” Assessed on that basis, he believes, the defence sector really doesn’t justify a place in sustainable funds.

It’s a broad and nuanced spectrum, and some ESG funds may feel there’s a place in the portfolio for certain defence stocks, particularly given the geopolitical backdrop.

But perhaps the bottom line for managers and investors strongly focused on sustainability is that there are more compelling investment ideas beyond defence, involving businesses actively working towards a cleaner, healthier or more resilient world.