Responsible investors should be wary of defence developments: Zenith

Increased global conflict has driven investor interest in defence sectors but there isn't a solid line between ESG and defence stocks, with the latter presenting more exposure across different sectors due to the current macro developments.

Zenith Investment Partners' Dugald Higgins said the current environment presents one of the clearest examples of how responsible investing is moving beyond screening frameworks into a more complex and politically charged place.

Higgins said one of the biggest challenges is defining what defence exposure looks like in modern portfolios, with the debate moving from the margins to the mainstream.

"We are seeing significant growth in defence-related investment vehicles, including from managers that align themselves with responsible investment frameworks," he added.

"That naturally creates confusion for investors and raises a more fundamental question around whether defence and ESG can coexist. We believe ESG is foundational and would argue its importance when assessing defence companies which pose high levels of regulatory, financial, legal and reputational risks. But the morality of these investments is a different question."

This follows a global trend where geopolitical tensions and government rearmament programs are driving inflows into the defence sector.

Defence investments can pose a wide range of material ESG issues and considerations for investors, including human rights violations, corruption, political instability, environmental and health impacts, land contamination and high carbon emissions, Higgins said.

Investors may hold indirect exposure to the defence sector through logistics businesses, manufacturers, and technology or communications companies whose products and services are used in military settings or conflict zones.

Exposure can also come through sovereign debt, including government bonds issued by countries involved in arms exports and the line between has become much harder to draw.

"Like it or not, even the best-intentioned investors probably have some exposure to the defence sector given its broad nature of supply chains and activities," Higgins said.

"At the very least, investors can be indirectly exposed through government bonds from countries involved in arms exports such as the US, the world's largest arms exporter."

He warns investors should be wary of treating the sector as either automatically acceptable or automatically excluded without deeper analysis.

"Investors are rightly reassessing the role of defence thematics in portfolios, particularly as the geopolitical landscape changes", he continued.

"But capital moving into this sector needs to be assessed through a genuine ESG lens. Labels alone are not enough. Investors need clearer definitions, greater transparency and a more rigorous understanding of the risks involved."

Higgins said responsible investment represents a broad spectrum of different approaches and isn't binary. Depending on how fund managers design their strategies, different elements can be utilised within a broader 'responsible' framework.

"Responsible investment is a priority for many investors, and for years armaments have often been screened out as part of that ethical position," Higgins said.

"However, being 'responsible' doesn't necessarily mean being 'ethical', nor is being ethical the same as incorporating ESG considerations into an investment process."