Europe’s ESG more than doubles defense holdings amid Ukraine war

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European sustainable investment funds’ exposure to defense stocks has more than doubled since Russia’s invasion of Ukraine, as policymakers insist on the need for a strong defense industrial base.

Around a third of European and UK funds focused on environmental, social and governance issues now have €7.7bn invested in the sector, compared with €3.2bn in the first quarter of 2022, according to an analysis for the Financial Times by Morningstar Direct.

While the rise in value is partly due to a rise in the share prices of defense companies since Moscow’s large-scale attack on Ukraine in February 2022, many investors have also accepted the governments’ argument that support for arms makers, long the subject of boycotts and protests students, should have positive social connotations rather than exclusively negative risks.

“The situation in Ukraine has really brought to the fore this idea of ​​’can we really defend ourselves?'” said Sonja Laud, chief investment officer at Legal and General Investment Management.

The fighting in Ukraine has sparked a debate about whether military contractors can be viewed as an ESG investment.

While investments in controversial weapons such as cluster bombs and anti-thermal mines, as defined in international treaties, are prohibited – a well-established status in the asset management industry – Laud believes that defense can be seen as sustainable.

Companies should still be assessed individually, as would the weapons they make and which countries they were sold to, “but we wouldn’t rule out defense as a matter of principle.”

The Morningstar analysis also shows that the number of European ESG funds holding more than 5% in aerospace and defense companies has tripled from 22 to 66 over the past two years.

BNP Paribas ETFs, including the Easy CAC 40® ESG UCITS ETF, breached 10% holdings in aerospace and defense, as did Paris-based Amundi’s Index Solutions CAC 40 ESG. Amundi declined to comment.

Morningstar European Equity Strategist Michael Field said the sector “has always been an ESG minefield, but that too is changing in the minds of investors”, with managers viewing it more “with an open mind” following the conflict in Ukraine .

The value of the funds’ holdings in the aerospace and defense sector is still small relative to their total assets, accounting for less than 1% of the €1.5 billion held.

However, the sector has gone from a “relatively uninteresting sector in the minds of many investors” to one where many “now feel they need to be invested or they could be left behind,” Field said.

MSCI Europe’s aerospace and defense index has risen 1.8 times since the start of 2022 as shares of top contractors have risen. In the broader investment market, holdings in defense-themed mutual funds and exchange-traded funds tripled from $5.8 billion in January 2022 to $17.6 billion in July 2024, according to LSEG Lipper data.

In the US, the value of ESG funds’ exposure to the aerospace and defense industry rose to €1.2 billion in the second quarter of 2024, from €779 million in the second quarter of 2022, according to Morningstar.

BlackRock iShares ESG Aware MSCI USA, one of the world’s largest ESG funds, includes US defense giants RTX and Northrop Grumman, as well as industrial conglomerate Honeywell. RTX and Northrop both received Pentagon orders, including for missiles and rocket engines.

The fund tracks an underlying index provided by MSCI and excludes controversial weapons and civilian firearms manufacturers and retailers.

Policymakers in the UK and Europe continue to push investors to support the sector.

In the UK, the new Labor government has promised to introduce a law to regulate agencies that rate companies’ ESG performance amid concerns about a lack of transparency in the rating process. Defense executives have previously warned that excessive or misapplied ESG considerations have often hurt the sector’s ability to attract investment and secure financial services.

David Coombs, head of multi-asset investing at Rathbones, said that while the UK manager did not add defensive stocks to its sustainable funds, it did consider “ESG risk” as part of an overall risk review for all its funds .

For example, Rathbones has owned Lockheed Martin since 2016, during which time the stock’s ESG risk has steadily declined according to its analysis.

But exposure to defense can cut both ways. “You have defense stocks that could be sold to the Israeli military. (There, the ESG risk is very high),” Coombs added.

Student protests have targeted universities with demands for divestment from companies linked to the Gaza conflict.