Defence’s running hot: is it too late to profit?

As Western countries confront the uncertainties of the modern world, from conflict in the Middle East to the escalating threat posed by Russia and China, public spending on defence is set to soar.

Under pressure from Donald Trump, the 32 Nato allies who met at June’s summit in The Hague almost all agreed to raise defence spending to 5% of GDP by 2035 – more than double the 2% target that Nato members are currently signed up to.

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There’s some scepticism about whether such targets are achievable given the straitened public finances of most European nations. And not all that 5% will go on the military – the Nato deal is for 3.5% spending on core defence with a further 1.5% earmarked for related infrastructure.

Even so, the sums are huge; in the UK alone, the prime minister earlier this year costed an increase in defence spending to just 2.5% of GDP at £13.4 billion extra each year. The European Union’s ReArm Europe initiative is an €800 billion (£695 million) programme, with €150 billion of public money.

For the defence industry, including many prominent UK business, that represents a bonanza. “We are at the start of a defence growth super-cycle,” says Jean Roche, fund manager of Schroder UK Mid Cap Ord (LSE:SCP).

Leading defence businesses have already begun to rise in value accordingly. In the UK, Babcock International Group (LSE:BAB) shares are up over 100% since the beginning of the year (to 24 July), while both BAE Systems (LSE:BA.) and Rolls-Royce Holdings (LSE:RR.) have risen over 60%; another winner is QinetiQ Group (LSE:QQ.), trading up 20% so far in 2025. Continental European defence stocks are also outperforming. Shares in Germany’s Rheinmetall AG (XETRA:RHM) have risen by more than 1,000% since Russia invaded Ukraine in February 2022.

Businesses with defence sector customers have also benefited. The US big data company Palantir Technologies Inc Ordinary Shares - Class A (NASDAQ:PLTR) counts the US Department of Defense and a string of intelligence agencies among its key clients; its stock is up by over 450% over the past year.

Too late to profit?

Such gains beg an obvious question – have investors yet to increase their exposure to defence missed the boat? It’s a reasonable concern, says Schroders’ Roche, but there are still opportunities, particularly if investors start to think of defence as a growth sector rather than a more cautious and defensive play.

“Stocks remain attractively valued relative to their global counterparts,” she says. “However, we would emphasise the importance of being exposed to the growth areas of the defence market.”

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Richard Hunter, head of markets at interactive investor, shares that view. “For some, historic valuations are beginning to look punchy, and as such the bar will be set increasingly high for future updates,” he says. “However, increasing commitment to defence spending, allied to a possible re-rating of the sector adds an intriguing set of possibilities to the mix.”

It is possible to bet on the defence boom through a portfolio of individual stocks. In the UK, Hunter thinks a case can be made for further investment in all four stocks mentioned above – Babcock, BAE, Rolls-Royce and QinetiQ.

ETF routes to defence theme

However, many investors will feel more comfortable with professionally managed exposure to this theme. They may be better suited to the growing number of exchange-traded funds (ETFs) that now track the defence sector.

One possibility is the HANetf Future of Defence ETF Acc GBP (LSE:NATP), which splits its portfolio into two chunks; roughly half the £2 billion fund is devoted to industrial defence stocks, while the other half focuses on cyber defence. The fund invests only in companies that generate their revenues from Nato countries and their allies.

“The cybersecurity holdings provide some diversification, but they also offer exposure to an increasingly critical area of defence,” explains Tom Bailey, head of research at HANetf, pointing to the increasing number of cyber attacks that originate from hostile nation states. “Modern conflicts are increasingly fought in the digital realm, requiring digital defence capabilities.”

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Another option is the VanEck Defense ETF A USD Acc GBP (LSE:DFNG), which was the first fund launched in this sector and now has almost £4.5 billion in assets under management. Like the HANetf fund, it invests across several defence themes, with holdings in both traditional aerospace and defence companies, and in areas such as cybersecurity and biometrics. However, despite being a much larger fund, its portfolio is much narrower; it currently has around 30 holdings compared to 60 at Future of Defence, which limits exposure to any single holding at a maximum of 5% of the portfolio.

It’s an important consideration, says Alex Watts, senior investment analyst at interactive investor. “While the performance of these products has been strong and the geopolitical argument is compelling, investors should watch out for excessive concentration,” he says. “Caution is warranted given the lofty valuations in the sector.”

Meanwhile, although the HanETF and VanEck defence EFTs are the best-known funds in this area, competition continues to grow. The Global X Defence Tech ETF USD Acc GBP (LSE:ARMG), launched last year, tracks the Mirae Asset Defence Tech index, which consists of the top 50 global companies earning more than 50% of revenue from defence and military contracts. Invesco Defence Innovation ETF GBP (LSE:DFNX) invests in core defence companies, but also in suppliers to the industry, including smaller businesses.

There are also a couple of European specialists, including WisdomTree Europe Defence ETF EUR Acc GBP (LSE:WDEP) and HANetf’s Future of European Defence ETF USD Acc GBP (LSE:NAVY), which was launched in April 2024 as a spin-off of the original global fund. However, Watts warns: “On the concentration point, the European options both hold over 90% of their portfolios within the industrials sector.”

The active fund managers backing defence names

For investors who do worry about diversification, a thematic defence fund is not the only way into the sector. There are also more broadly-based stock market funds with significant exposure to defence.

Recent analysis from the Association of Investment Companies (AIC) identified four investment trusts that now hold more than 5% of their assets in defence: Law Debenture Corporation Ord (LSE:LWDB), Invesco Global Equity Income Trust ord (LSE:IGET), Global Opportunities Trust Ord (LSE:GOT) and the Schroder UK Mid Cap Fund, managed by Roche, which has almost 11% invested in defence stocks.

Elsewhere, investment trusts City of London Ord (LSE:CTY) now holds a little over 4% of its assets in BAE Systems, while JPMorgan Claverhouse Ord (LSE:JCH) is 2.3% invested in BAE and also owns a 2.7% stake in Rolls-Royce. “BAE provides some of the world’s most advanced, technology-led defence, aerospace and security solutions and currently has a significant order book,” explains Anthony Lynch, manager of JPMorgan Claverhouse. “Rolls-Royce is a powerful player in the aerospace market and has benefited significantly from increasing defence spending.”

Among open-ended funds, meanwhile, Rathbone M-A Strategic Growth has made high-profile investments in Lockheed Martin Corp (NYSE:LMT) and Thales (EURONEXT:HO). L&G UK Equity Income has a significant over-weight holding in BAE.

Finally, one interesting question to address is where defence holdings fit into a portfolio designed with environmental, social and governance (ESG) principles in mind. Traditionally, funds managed through an ESG lens have steered clear of the sector. But some in the ESG movement argue that in an era of rising aggression from Russia and other threat actors, investment in defence should be seen as a socially responsible activity.

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The EU, which is anxious to encourage private sector investment in defence as well as increasing public spending, has also positioned itself carefully on this issue. The EU’s sustainable finance rules do not place wholesale restrictions on defence investment, but there is a veto on financing companies involved in the production of “controversial weapons” – the definition of such weapons is somewhat woolly. 

In an interview with interactive investor last summer, City of London manager Job Curtis said that he “struggles a bit” with why some investors and some sustainable funds exclude defence companies on ethical grounds. Curtis said: “If you don’t have companies making good weapons, we’re going to be defenceless against people like Putin today or, going back in history, if we didn’t have Spitfires in 1940, we’d have probably got invaded. I think there are some people who just don’t believe in it on religious grounds, say. But I think overall it’s a practical effect. When you’ve got aggressor countries out there, you need companies to make good equipment.”

HANetf’s Tom Bailey says: “We’re going to need more guidance from regulators on where defence fits into ESG labelling regimes. Perceptions have definitely changed since Russia’s invasion of Ukraine.”

Ultimately, investors will need to consider their own consciences. Some will remain utterly opposed to investing in weapons and related areas; others may worry about specific companies – for example those that sell defence equipment to countries whose policies and actions they disprove of.