Why Europe's largest investors are building their defense war chests

As war rages on Europe’s doorstep and authorities across the region explicitly encourage institutional investors to support national security, some European pension funds are changing their investment policies to put more money to work in the defense industry.

Last month, Danish pension funds told Pensions & Investments that the war in Ukraine had led to a rethink of allocations to defense assets. Some had already been investing — carefully and always with a responsible investment framework in mind — in defense and aerospace companies, but the situation in Ukraine and calls from the government to bolster defenses has sharpened their focus on the sector. That’s not just because of the social responsibilities they recognize in helping countries to defend their borders and citizens, but also due to the investment opportunities out there.

Now, a number of European pension funds in neighboring countries have told P&I that they, too, have updated their thinking and are looking for opportunities to add to their own portfolios by investing more and in some cases being less constrained in how they allocate cash to defense-related companies.

The defense sector has also landed on their radars amid calls from authorities for more investment in the sector, including the European Commission’s proposed European defense industry strategy, which aims to make the European defense industry stronger, more responsive and more innovative, and a push by Danish Prime Minister Mette Frederiksen to strengthen the country’s defense industry. Finland became a member of the North Atlantic Treaty Organization last year, while Sweden became a full member in March.

And now the U.K. HM Treasury and the Investment Association — which represents U.K. managers with more than £8.8 trillion ($11 trillion) in assets — have thrown the gauntlet down, with a joint message on April 23 stating that defense company investments contribute to national security, defend “the civil liberties we all enjoy, while delivering long-term returns for pension funds and retail investors. That is why the U.K.’s world leading investment management industry supports our defense sector,” with the IA’s member managers investing £35 billion in U.K. defense firms, it said in a statement.

But the key message related to environmental, social and governance factors — potentially a sticking point for some investors when it comes to investing in defense assets: “Investing in good, high-quality, well-run defense companies is compatible with ESG considerations as long-term sustainable investment is about helping all sectors and all companies in the economy succeed,” the statement said.

IA representatives were not available to comment further. None of the U.K. pension funds contacted for this story were available to comment.

While there may be more encouragement, it doesn't make things any easier in terms of the due diligence pension fund executives have to exercise. For those that are working out how to invest or continue investing in defense companies, there’s no easy answer beyond intense due diligence and analysis, sources said.

“On a general level, conventional weapons and simple small arms can also be used in violation of international rules,” said Kiran Aziz, head of responsible investments at KLP, Oslo. Total group assets are 1.02 trillion Norwegian kroner ($93.5 billion).

“Following up on this is challenging. Firstly, no one makes public an intention not to follow international norms; secondly, there will be disagreement about what constitutes a breach of norms and rules; and thirdly, it is not the producers who are the ones that investors relate to, which controls the use of weapons that have already been sold. As an investor, it is difficult to see that we have the tools to deal with this,” she said. “But complexity does not exempt from responsibility,” she added.

Pension funds based in Finland that responded to P&I were unanimous on the development in approach to investing in defense assets, with the war in Ukraine a clear turning point for their investment policies.

The €60.5 billion ($64.4 billion) Ilmarinen, Helsinki, last updated its responsible investment policy this year, with one changed area related to its approach to the defense sector.

“We can now invest in NATO-based defense sector companies also in case they have controversial weapons-related revenue,” said Karoliina Lindroos, head of responsible investment. “Previously all companies with involvement in controversial weapons were excluded.”

But no decision is taken lightly. “We consider defense as a high-risk sector and investing in this sector requires undergoing an internal process prior to investing. We still cannot invest in companies that manufacture biological and chemical weapons, regardless of where the company’s headquarters are located,” she said.

The key reasons for the change are the geopolitical situation and the security landscape.

“Responsible investing approaches evolve over time and we observed the changing operational and security context and moved forward to update our approach,” Lindroos said. Executives at the pension fund have observed defense-related discussions in Europe and in Finland; for example, the Finnish Sustainable Investment Forum in partnership with the Finnish Venture Capital Association organized an event on weapons and defense sector-related investing last year, Lindroos added.

Aerospace, defense stocks rise

Many of the Danish pension funds that said they had altered their stance on defense assets in the wake of the Ukraine war from a social responsibility point of view also said there are opportunities to be found in the sector — a view shared by other European funds.

The S&P 500 Aerospace and Defense Sub-Industry Total Return index gained 28.09% for the period Feb. 24, 2022, through May 6, compared with a 25.13% return for the S&P 500 Total Return index for the same period. The defense sector index gained 15.46% for the 12 months ended Feb. 23, 2022.

Timo Loyttyniemi, CEO at €22.8 billion Finnish state pension fund Ver, Helsinki, said the plan started internal discussions over clarifying its policy right after the Russian aggression in Ukraine started Feb. 24, 2022.

Executives changed some wording in VER's policies to allow for investments in the defense industry in general.

The first decision was not to exclude defense-related investments. “Now the thoughts are more on how to find positive investment opportunities and how companies are transforming themselves,” Loyttyniemi said. Controversial weapons are excluded from the investment universe, however.

Overall, it was a “very easy and straightforward decision to make. Security is absolutely a key element and priority for the societies. Defense is part of security,” he added.

And Helsinki-based Varma, with €60.9 billion in assets, revised its principles of responsible investment in 2022, a spokesperson said.

“The catalyst was war in Ukraine,” she said. The change saw Varma apply “enhanced high-risk sector due diligence to these investments, suggesting a more nuanced and rigorous approach to engaging with (the) airspace and defense sector.”

Executives have identified industries that pose significant sustainability challenges and subject them to enhanced monitoring and special scrutiny, she added.

For defense specifically, Varma analyzes the industry, products and services, and client base of such companies. Investments are permitted as long as business related to controversial weapons does not exceed 5% of a company’s activities. “Additionally, these activities must serve the purpose of conflict prevention and defense of sovereignty in compliance with international arms control treaties,” she said.

Compliance with international treaties and conventions is also critical, and Varma engages with companies to try to rectify situations where an investee firm has violated local laws or international agreements.

Norway’s KLP is monitoring the defense sector, Aziz said.

The pension fund is invested in the aerospace and defense sector as defined by MSCI, “which clearly shows stronger returns than the rest of the market from the end of 2021 after Russia’s invasion of Ukraine. As governments around the world once again find themselves in an arms race, market shares in the military industry are skyrocketing,” she said.

Executives reviewed its investments in 2021, deciding not to invest in companies that produce weapons that violate fundamental humanitarian principles through their normal use, Aziz said. That led to the exclusion of 14 companies.

Sweden’s AP4, Stockholm, with 499.6 billion Swedish kronor ($45.9 billion), does not invest in cluster weapons and mines, nor companies that are directly involved in weapons of mass destruction, said Magdalena Hogberg, head of allocation, liquid markets and analysis. “We do however hold investments in other parts of the defense sector and have from time to time increased exposure to the industry. One such example was an increased exposure to companies likely to benefit from increased spending on defense following Russia’s invasion of Ukraine in 2022,” she said.

As with Danish pension funds, investors in other parts of Europe put a hard stop on investing in controversial weapons.

PGGM has almost €350 million invested in the defense sector on behalf of Pensioenfonds Zorg en Welzijn, Zeist, Netherlands, which has €237.8 billion in assets. The investments are part of passive allocations, a spokesperson said.

“PFZW participants’ hesitations about investments in defense companies contribute to a specific policy to exclude investments in companies that produce (parts of) controversial weapons. This regards weapons of mass destruction (nuclear, biological, chemical) and anti-personnel mines, cluster bombs and depleted uranium munitions. The above-mentioned mandates have not changed over the years and are still in place,” he added.

AMF, Stockholm, with 790 billion kronor in assets, has “noted the changed tone in the broader discussion… (but) our internal conversation around responsible investment hasn’t changed based on this,” a spokesperson said.

The fund has no direct investments in the defense industry — “not due to any ESG restrictions though; we can invest in such companies,” the spokesperson said.

And The Hague, Netherlands-based Pensioenfonds Metaal & Techniek, which has €84.5 billion in assets, “is not principally against investing in the defense industry,” but does not invest in companies that are involved in the production of controversial weapons and weapons for civilian use, a spokesperson said. “If companies within the defense industry meet the regular financial and sustainability requirements of PMT's various investment portfolios, they can in principle be invested in.”

The pension fund implemented a new exclusion policy on April 1, banning investment in companies involved in blinding laser weapons and those that leave undetectable fragments in the body. Companies involved in the sale of small arms for civilian use have also been excluded.

Interest in defense-related exposures is growing among exchange-traded fund investors, too, with the VanEck Defense UCITS ETF breaking the $500 million mark in the year following its launch on March 31, 2023. The ETF had $678 million in AUM as of May 6. Year-to-date returns were 23.16% as of that date.

“When we launched the fund a little over a year ago, it was still in the environment where the ESG focus was … making a lot of institutional investors reluctant to look at investing in the defense industry,” said Martijn Rozemuller, CEO of VanEck Europe, the European arm of the global asset manager, which had a total $101.9 billion in AUM as of March 31.

Governments across Europe, mainly in the Netherlands and Germany, were already urging pension funds to rethink their stance toward investing in the assets, he said.

“Over the last 12 months there’s definitely been a shift, but we also do have to be cautious on being overly enthusiastic” about pension fund involvement, he said, adding that as far as he is aware, there is no European pension fund with direct investment in the ETF.

Rozemuller thinks about one-third of investors are retail, one-third will be independent wealth managers, and the remainder is family offices and private banks.

“Insurance companies and pension funds are the hardest category — I think it will take longer before they have adjusted their rules of engagement,” Rozemuller said. “But I know they are looking at it. A big question is whether they need to use an ETF for this or just invest directly in the underlying companies,” he added.

The manager is organizing an event aimed at the Dutch pension fund industry for the summer, he said.

Despite the extra work needed for pension fund engagement, the defense ETF has still “been pretty much our most successful launch in the last 10 years in Europe,” Rozemuller said.