(March 19): ESG fund bosses battered by years of underperforming returns are rapidly redefining their mandates to make room for highly lucrative defence bets.

Since Russia’s 2022 invasion of Ukraine and through the end of the fourth quarter of last year, the share of sustainable funds in Europe that devote at least 1% of their portfolios to aerospace and defence stocks has climbed by 37% for actively managed funds and 67% for passive products, according to data compiled by Morningstar Direct for Bloomberg. 

The development marks a stunning about-face for a corner of the fund market that long treated such assets as uninvestable.

“Many ESG investors, five to 10 years ago, if you had a fund manager in the room who said, ‘Do you buy defence stocks?’ It would be laughable,” said James Penny, UK chief investment officer at TAM Asset Management Ltd. Now, they’re doing investments they “would’ve never done” before, he said.

For ESG (environmental, social and governance) investors battered by years of below-average returns, it’s an opportunity to tap into an asset class that’s outperforming the market by a wide margin. Since February 2022, the S&P Global 1200 Aerospace & Defence Index has added about 70%. By comparison, the Stoxx Europe 600 Index is up roughly 25%, while the S&P Global Clean Energy Transition Index has lost more than a third of its value in the same period.

According to data compiled by Bloomberg, Rheinmetall AG currently sits in more than 680 ESG-registered funds. Leonardo SpA is held in some 485 ESG funds, and there are roughly 375 such funds that hold Lockheed Martin Corp. About 465 ESG funds own shares of BAE Systems plc, the data show.

Holdings in weapons manufacturers based in Europe have proved particularly lucrative. Shares of Germany’s Rheinmetall, which produces tanks and ammunition, are up more than 1,300% since February 2022. Leonardo, an Italian maker of weapons systems and military vehicles, has gained over 600%.

“The performance being delivered by defence stocks at the moment will only entice further people into it,” Penny said. “Whether the defence sector has already delivered a lot of what it can is up for debate, but there will certainly be more people reassessing their sustainability mandates to see if they can include it.”

It’s not the first time that fund managers have relaxed their mandates to allow them to “own more stocks that do well, so that they can generate performance,” Penny said. The market is “very, very adept at manufacturing a narrative if it wants one,” he said.

For example, Chevron Corp is held in more than 1,000 ESG funds, according to data compiled by Bloomberg. Exxon Mobil Corp sits in more than 1,100, while Saudi Aramco has found a home in over 550 ESG funds, the data show.

Officials in Europe are now doing what they can to remove ESG regulatory barriers that might make it harder for investors to support the defence sector.

Earlier this month, European Union member states requested that the European Commission come up with a list of proposals to boost private finance for defence. And Commission president Ursula von der Leyen has since signalled that the bloc will do everything it can to free up capital, declaring that with “European values, democracy, freedom, the rule of law” now under threat, “nothing is off the table”.

Regulators in the UK have already made clear that existing sustainable investment rules don’t prohibit fund exposures to the defence industry. And in the EU, current ESG rules emphasise disclosure rather than restrictions. 

Euronext NV chief executive officer Stephane Boujnah said there needs to be a break with “yesterday’s ESG” and a shift towards “tomorrow’s ESG”. 

“Companies in the defence and armaments sectors often appear at the bottom of the list in disclosure rankings, particularly when it comes to governance,” he told reporters in Paris on Tuesday. “And that’s often what stands in the way of investment funds to include them. We need to change these requirements for those sectors.”

Graeme Bencke, a fund manager at Amati Global Investors Ltd, said ESG-focused investors are keen to adapt to the geopolitical moment. So the narrative has shifted away from “a lot of moralising”, which in the past has meant that “defence definitely suffered,” he said. 

From a national security perspective, “we need to think about and be invested in defence,” he said. Other asset managers are ready to review their policies in light of the security threats facing Europe.

A spokesperson for Banque Pictet & Cie SA said the firm is “closely monitoring the evolving geopolitical landscape and its implications for our investment strategies and discussing and debating the topic internally and with our stakeholders.” Controversial weapons, meanwhile, have been excluded from all of Pictet’s investment strategies since 2011, with additional exclusions on investments in weapons for its responsible-investing strategies.

“There’s a lot of performance up for grabs in the defence sector,” Penny said. And that’s more of a driver than any case there is to be made in favour of defence assets from a sustainability point of view, he said.

If they “really want to invest into defense, they will find a narrative that fits that,” he said.

Uploaded by Felyx Teoh