How to invest in the defence industry with ETFs

In the relatively peaceful post-Cold War era, governments around the world were able to implement large-scale cuts to defence budgets and redirect these funds elsewhere in the economy – a process frequently referred to as the “peace dividend”. However, the ongoing war in Ukraine, tensions between China and Taiwan and various Middle Eastern conflicts in recent years has drawn increased focus on how this sustained underinvestment has hindered domestic defence capabilities.

The defence industry could see a big shakeup under the Trump administration. US president Donald Trump has long been a critic of NATO, claiming that many members from Europe are ‘free-riders’ that rely on US taxpayers to fund international security interests. Recent events affirm that he is so far sticking to these sentiments.

According to a recent NATO report, 23 Allies met or exceeded the defence spending target of 2% as a proportion of GDP that was set following the Defence Investment Pledge in 2014. While this marks significant progress from just 3 members meeting the target in 2014, pressure is mounting for European Allies and Canada to go further with their commitments.

Trump ratchets up the pressure on Europe

In preparation for Trump’s return to the White House, European NATO members had already been discussing raising the alliance’s target to 3% of GDP at its next annual summit in June 2025. However, it now seems such promises will not satisfy Trump who is demanding that NATO countries should spend 5% of their GDP on defence. This is a level that no NATO country, including the US, currently achieves.

There is now consensus on the need to ramp up defence spending in Europe to bolster the continent’s defence capabilities, but views are divided on the proposal to deploy peacekeepers to Ukraine in the event of a peace deal. Although a resolution of the Ukraine war could remove some impetus to increase overall spending, there is clear momentum to continue investing in domestic defence capabilities given the realisation of how quickly conflicts can materialise.

How might the defence industry evolve?

Traditionally, the defence industry exhibits anti-cyclical behaviour as government defence spending and contracts provide it with a degree of revenue stability. Significant capital investment into technological advancements, lengthy product development cycles and tight regulatory requirements present high barriers to entry which has resulted in a concentrated landscape whereby a few major players dominate.

Industry commentators are looking to see how the Trump administration may disrupt this established defence hierarchy. Pete Hegseth, Trump’s pick for defence secretary, has emphasised the need to enhance competition and innovation in weapons development which has long been criticised as being slow and anti-competitive.

Musk’s involvement with reviewing the Pentagon’s spending has also raised concerns about potential conflicts of interest given that SpaceX (one of Musk’s companies) already has contracts with the government and is currently in discussion with other tech challengers in the defence space to form a consortium that will jointly bid for US government contracts – the group is also expected to include Palantir Technologies, Anduril and OpenAI demonstrating how capital could be directed towards a mix of public and private companies.

There are already examples that legacy ‘prime’ defence contractors in the US are no longer first in line to get their slice of the US defence spending pie as competition is rising from new defence tech companies. Last year Anduril and General Atomics were chosen over Lockheed Martin, Northrop Grumman and Boeing by the US Air Force to develop and test its first batch of drone wingmen in what was seen as a seminal event for the industry. The war in Ukraine has turbocharged the development for technologies such as drones and unmanned systems which play to the strengths of these defence tech companies. However, sceptics are questioning how much the US military would be willing to take risks on giving major defence programmes to smaller, more inexperienced players.

Overall, as competition in the defence industry intensifies, companies will need to innovate and differentiate their offerings to secure contracts and maintain their competitive edge.

Europe vs. US defence companies

Since Trump’s victory in the US presidential election in November 2024, the share prices of ‘prime’ US defence companies (Lockheed Martin, Boeing, General Dynamics, Raytheon and Northrop Grumman) have lagged their European counterparts. This outperformance can partly be attributed to a projected increase in Europe’s share of global defence spending which is expected to grow from 16% to 21% by 2029 according to Morningstar. However, the degree that this spending will fall to European defence companies remains to be seen as between the start of Russia’s invasion of Ukraine and June 2023 around 78% of EU defence procurement went to non-EU defence companies of which 63% went to US companies, according to the European Defence Industrial Strategy (EDIS).

France, the world’s second largest arms exporter (after the US), has voiced its opinion that European taxpayer money should be channelled towards European-made weapons and not to the US. However, US defence products may still be on EU leaders’ shopping list as a way of killing two birds with one stone: appease Trump by increasing spending on defence and improve the trade balance with the US to avoid potential tariffs.

Defence spending is already making its way into prime contractors’ top line revenue. According to Morningstar, sales in European contractors increased 20% on average over the period 2021-23 with margin expansion increasing as companies benefited from economies of scale from higher production. Margin expansion in the US was more muted over the period which Morningstar attributed to a higher proportion of lower-margin development work and cost growth.

Where are the risks?

Billions pouring into the defence industry sounds like an attractive proposition from the perspective of promoting national security or investing into defence companies. However, the devil will be in the detail with regards to its overall effectiveness. From a national security point of view, attention should be placed on what the money will be spent on.

While NATO allies agreed in 2014 that at least 20% of defence expenditure should be devoted to developing and acquiring new equipment, members need to be mindful that the remaining proportion is not used wastefully. Governments will need to conduct regular audits, prioritise spending on essential programs, and cut down on bureaucratic inefficiencies to enhance national security without compromising other vital public services.

From an investor’s perspective, further attention should also be placed on the structure of the government contracts awarded given the influence that this can have on companies’ bottom lines.

• ‘Cost-plus’ contracts see the government take on more of the risk as they cover the expenses of the contractor plus a profit.
• Fixed-price contracts use a predetermined price set by the government which place higher risk on the contractor if the programme is subject to delays or cost overruns.
• Contracts can also include provisions for performance incentives, such as cost savings or meeting specific performance targets.

Boeing is an example of a company which has been saddled with various programmes on which it loses money due to fixed-price contracts. In their fourth-quarter 2024 earnings call, the company reported US$1.7bn in pre-tax charges on their fixed-price programmes due to cost pressures with operating margins for the overall Defence, Space & Security division at -41.9%. Companies will need to navigate the risks involved with the complexities of government contracts by implementing effective cost and project management strategies to maintain profitability going forward.

Another key risk is on supply networks. Perhaps luckily, fighter jets, tanks and drones do not grow on trees with the defence industry being renowned for having lengthy and complex supply chains. The air domain arguably has the most complex supply chain given its international footprint and the technological requirements. For example, the F-35 fighter jet programme led by Lockheed Martin has 1,650 high tech suppliers. The nature of these supply chains creates vulnerabilities as it exposes the industry to geopolitical risks as well as increasing dependency risks for imported critical materials.

US and European procurement of some vital components and materials is highly dependent on non-allied countries. China is a major global defence player but, it has also embedded itself in the supply chains for critical raw materials representing a key dependency for defence manufacturers. As geopolitical tensions and threats of a transatlantic trade war continue to bubble, we should be reminded of the importance of supply chain resiliency given that disruptions at any point across global supply networks can have widespread implications.

Finally, the recent surge in share prices of defence companies is worth noting. We have been positive around the opportunities created by higher defence spending for some time, but with the latest price action there is a risk that markets have already moved a great deal in the short term and the true financial impact on companies is yet to be determined.

How can you buy into the defence industry without buying individual shares?

As new competitors enter the market, there will naturally be winners and losers from those successful in obtaining the rewards on offer from government contracts. As a result, many investors have sought a basket of stocks to diversify across the defence industry. A convenient way to do that is through an ETF (an Exchange Traded Fund) that buys a range of stocks in defence and related industries, to play the theme.

An exchange traded fund can be bought just like a share on the stock market, but it’s a fund that holds a portfolio comprising a range of shares to represent a broad index, or they can be focused on a particular sector such as defence.

Various fund providers have launched ETFs in this area in recent years as they battle it out to take investor flows. Some products, particularly the earlier launches, have hoovered up substantial inflows as investors look to add to their portfolios as a hedge against geopolitical risk as well as to capitalise on the structural tailwinds of increased government spending.

As with many thematic areas, there is not a standardised way of capturing the defence theme. Some products can tend to target the wider defence ecosystem, and there is often a trade-off between purity to the theme in terms of underlying revenue from defence activities, and diversification. Many companies have civil or non-defence parts to their business, so the ETF investor is not getting exposure purely to defence.

That’s something to bear in mind when looking at different options. Those researching the area should examine the index being followed and the holdings in the ETF to ensure it’s what they are looking for. For instance, some have larger allocations to the aerospace industry, others to the technology sector including cybersecurity.

Remember, even when diversifying through an ETF it’s still risky. All investments can go down as well as up, and very specific funds like this can experience greater ups and downs than the wider market.