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Defence names are often excluded from environmental, social and governance indices, having been long considered ‘sin stocks’ along with tobacco and alcoholgopixa/ISTOCK

The war in Ukraine has changed the geopolitical landscape in many ways, including prompting several democratic nations to increase defence spending.

Among them are North Atlantic Treaty Organization (NATO) members like Germany, which could increase its defence budget by 50 per cent this year alone, making it the world’s third-largest spender on military behind the U.S. and China.

The rise in spending could result in increased revenues for defence companies and renewed interest from investors. 

Defence names are often excluded from ESG (environmental, social and governance) indices, having been long considered ‘sin stocks’ along with tobacco and alcohol, says Daniel Straus, director of exchange-traded funds (ETFs) and financial products research at National Bank of Canada Financial Markets.

Yet, the sector may have a new cachet even among ESG investors, given these firms manufacture weapons and technologies helping a democratic nation defend itself from invasion, he adds.  

“In the past, most people haven’t wanted their investments associated with the messy business of basically killing people,” he says. “But now they’re seeing Javelin missiles used for self-defence.”

Despite the increased spending on defence, the S&P Aerospace & Defense Select Industry Index is down about 8 per cent, year to date due to the larger drawdown on equities over concerns of rising inflation, higher interest rates and recession fears. Still, the sector has seen strong growth over the last decade and is expected to see steady gains in the years ahead.

Mr. Straus says defence is one of the sectors his firm’s economists identified as having global importance long term, alongside genomics and biotechnology. 

“They pointed out that pandemics are generally associated with greater global instability and that, very sadly, is accompanied by increased conflicts and war,” he says.

Investors looking to invest in the defence sector can gain exposure through a handful of ETFs:

iShares U.S. Aerospace and Defense ETF (ITA-A)

Management expense ratio (MER): 0.42 per cent

Assets under management (AUM): US$3.7-billion

Year-to-date performance: down 44 per cent (data from Morningstar as of May 31).

The largest ETF in the sector, ITA holds 35 companies likely to see increased demand for weapons they manufacture, from drones to anti-tank missiles to space-based defence systems. 

ITA uses a market-capitalized weighting – ranking stocks based on their price multiplied by the number of shares outstanding – though it does cap any one holding at 22.5 per cent of the portfolio, says Lara Crigger, New Orleans-based editor in chief at research firm VettaFi (formerly ETF Trends). “Overall, you have 75 per cent of the fund’s portfolio in the top 10 holdings.”

Its two largest positions are Raytheon Technologies Corp. (RTX-N), maker of the surface-to-air missile system MIM-104 Patriot in demand among NATO members, and Lockheed Martin Corp. (LMT-N), maker of the Javelin missile nicknamed ‘St. Javelin’ by Ukrainians for destroying Russian tanks, which account for almost 40 per cent of its AUM.

While there is concentration risk, Jeff Kaminker, portfolio manager and president of Frontwater Capital, says the ETF offers “above-average growth and a small dividend.” It has a 10-year annualized return of about 14 per cent, on par with the S&P 500.

Although ITA performed well in March after the war’s start, similar to other ETFs in the sector, it has since pulled back due to its exposure to commercial aerospace – Boeing Co. (BA-N) is its third-largest holding – as inflation is forecast to erode demand for travel, Ms. Crigger notes.

SPDR S&P Aerospace and Defence ETF (XAR-A)

MER: 0.35 per cent

AUM: US$1.4 billion

YTD performance: down 7 per cent

XAR’s 33 holdings are similar to ITA, only it uses an equal-weighted index to build its portfolio. With each company limited to about 4.5 per cent of AUM, “you’re getting a more balanced approach and not overly exposed to any one stock position,” Mr. Kaminker says.

XAR’s portfolio, in turn, gives investors greater exposure to companies like Hexcel Corp. (HXL-N), which makes components for the F-35 fighter jet used by the U.S. and soon by Canada, than ITA, offering additional diversification.

Still, the equal-weight strategy may provide “less of an accurate capture of what’s really going on in the defence industry” as the largest companies could see most of the revenue growth, Ms. Crigger notes.

Invesco Aerospace & Defense ETF (PPA-A)

MER: 0.6 per cent

AUM: US$1.3 billion

YTD performance: flat

Another market-cap-weighted fund, PPA offers investors a “middle ground” between ITA and XAR by capping the exposure to any one security at 10 per cent, Ms. Crigger says.

With 55 holdings, the ETF includes the largest contractors, including its top holding Northrop Grumman Corp. (NOC-N), accounting for about 8 per cent of the portfolio. The U.S. firm manufactures a variety of weapons from munitions to jet fighters to satellites and drones.

SPDR S&P Kensho Future Security ETF (FITE-A)

MER: 0.45 per cent

AUM: US$29.6 million

YTD performance: down 11 per cent

FITE offers a different spin, with exposure to cybersecurity, which is “a major concern not just in the realm of global geopolitical conflict, but also just basic corporate cybersecurity,” Mr. Straus of National Bank says.

Its underlying index includes seven key categories: robotics, wearable technology, drones, virtual reality, space, cybersecurity and advanced border security. Although large defence names are among its 67 holdings, including Lockheed Martin, FITE also holds cybersecurity firms with defence sector exposure other ETFs do not, like NetScout Systems Inc. (NTCT-Q) and Palo Alto Networks Inc (PANW-Q).

As well, FITE involves less concentration risk as no one holding exceeds 3 per cent, a result of using “natural language processing” among other proprietary measures to create its index, Mr. Straus adds.

Ark Space Exploration and Innovation ETF (ARKX-A)

MER: 0.75 per cent

AUM: US$334.5 million

YTD performance: down 21 per cent

The only actively managed ETF in the list, run by money manager Cathie Wood, ARKX “has less to do with defence than with satellite and (space) launch technology,” Mr. Straus says.

Yet ARKX’s holdings still offer significant exposure to large defence contractors, which increasingly look more like space and technology companies, he adds. These include its top two positions: Trimble Inc. (TRMB-Q), providing computer systems supporting the U.S. military, and Kratos Defense & Security Solutions Inc. (KTOS-Q), which builds drones and technology used in cruise missiles. Together, these stocks make up about 18 per cent of the portfolio.

“One challenge is that as an actively managed fund, you can’t say with certainty it’s going to give you exposure to those companies all the time,” Mr. Straus says. “So, you’re relying on the manager to take positions opportunistically,” which may or may not increase exposure to defence.