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Can we defend defence companies as sustainable investments?

This blog was originally about the problem of fund labels such as ESG, sustainable or responsible for investors and advisers. The fact that I use three names here illustrates the issue already. But press coverage about bank analysts putting forward the case for defence companies for sustainable investment has made me change the subject.

Integrating ESG or sustainable factors into portfolio management, analysts and managers consider two aspects: mitigating the risks relating to ESG factors, and looking at ESG related opportunities. The classic example is on climate change. Portfolio analysts look at which companies will be worst affected by climate change and look to avoid those companies in a portfolio. At the same time, there are long-term investment opportunities relating to renewable and sustainable energy.

Defence companies are shunned by some ESG funds. While some ESG fund rating analysts pointed out that ESG funds may not necessarily exclude such companies due to the nature of the ESG investment process (an argument which may surprise investors and advisers which I will discuss in another blog), defence companies are often excluded by the negative screening process used by fund managers. By far, exclusion is the most common strategy adopted by sustainable/responsible/ESG funds in Europe.

The bank analysts quoted in the press article argued that the Ukraine situation “opens the aperture on their definition of defence”. One large sustainable fund manager who reversed their stance on defence companies stated that “investments in the defence industry are of key importance to uphold and defend democracy, freedom, stability and human rights”.

Based on these arguments, the defence industry now represents an ESG opportunity. But that looks oversimplistic:

  1. The need to defend democracies, freedom, stability and human rights has been there for a long time. Why does it take until the Ukraine crisis for ESG/sustainable investment analysts to realise the “potential” of defence companies? Shouldn’t that have been considered a few years ago when conflicts relating to the suppression of freedom and democracy happened in other parts of the world?

  2. As Gerry Celaya, our Chief Strategist pointed out, with more European nations preparing to increase spending on security, these companies may have upside potential. BUT how does an increase in security spending necessarily relate to the ESG/sustainability/ethical reasons quoted by the above analysts and managers?

  3. How can an investment manager distinguish arms sales that defend democracies and human rights, and those that end up with nations that use these arms to suppress them? After all, it is usually the state, not private defence companies, that decides how the arms are used.

Perhaps some ESG/sustainable fund managers are finding value in defence companies. To justify inclusion in the portfolios, they have to come up with an ESG or sustainability compliant reason. The reason may sound very timely with a high moral ground but is also over-simplified.

More importantly, does the end investor of a retail ESG/sustainable/responsible investment fund understand and agree? Can investment in defence companies really make a measurable impact in defending freedom, democracies and human rights (“purposedly doing good”)? Or we are avoiding doing wrong by investing in defence companies? Or maybe to avoid doing wrong is still to avoid defence companies?

The Ukrainian tragedy has reminded people that weapons are needed sometime. But perhaps this debate is just yet another reason for scepticism over ESG labelling.

James Chu CFA

Head of Investment Solutions

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