Defending your portfolio

David Prosser on how why it may make sense to add a defensive element to your investments.

Amid the stock market chaos of recent weeks, it would be reasonable to expect at least one sector to have performed strongly. Surely defence stocks have been boosted by war in Iran, which only adds to the pressure on governments to spend more on the military? As it turns out, that isn’t what’s happened – shares in European defence companies have fallen 4% since the conflict began.

However, the explanation for that slide is mundane. The reality is that many large fund managers have raised their cash holdings in response to the conflict, shifting automatically to more defensive asset allocations. That has seen them sell out of holdings in every sector – including defence – to such an extent that price corrections were inevitable.

The question now is where we go from here. Making predictions about this war is a fool’s game given the capricious nature of all sides, but one medium-to-long-term impact does seem certain. Governments were already committing more to defence spending, particularly in the context of Russia’s invasion of Ukraine and Donald Trump’s demands for European members of NATO to pay more of its budget. With geopolitical tensions now even more heightened, that trend must surely accelerate.

The UK, for example, has promised to spend an extra £2.2bn on defence, setting a course towards defence spending worth 2.5% of GDP by 2027, and 3% by the next parliament. Germany is also raising spending significantly, an important departure given its longstanding reluctance to increase military funding. More broadly, the European Union is currently deploying the “ReArm Europe” initiative, an €800bn defence programme aimed at strengthening the continent’s security and reducing its dependence on non-European suppliers.

Analysis published last year by analysts at HANetf illustrated the magnitude of the sums at stake. It looked at a bull case where NATO’s European members increased their defence budgets to 5% of GDP by 2029; this would result in an additional $350bn of spending on defence equipment – more than half of the global defence sector’s revenues in 2023.

Many businesses could share in this windfall. The defence sector now extends well beyond traditional military hardware, particularly as new technology transforms how wars are fought. Artificial intelligence, for example, is now widely used to improve targeting and logistics; drones are routinely deployed for surveillance and strike missions; space represents a new frontier.

There’s also increased focus on cyber security, with many countries seeing cyber as an important new attack vector.

In other words, the fundamentals for the defence sector look set fair. The recent sell-off, as fund managers have shifted into cash, might even be considered an opportunity.

Still, in these volatile conditions, diversification will remain important. While there are a number of specialist defence funds many investors will feel more comfortable with a vehicle offering good exposure to this sector, but also to a range of other holdings.

In which case, a well diversified investment trust could be a good option, with a number of funds in different sectors currently holding major stakes in both European and North American defence companies. Good examples include BlackRock Greater Europe, European Opportunities Trust, Global Opportunities Trust, Invesco Global Equity Income and Schroder UK Mid Cap Fund.

The structure of an investment trust is particularly attractive during volatile periods for stock markets. Open-ended fund managers are currently dealing with large inflows and outflows of investors’ cash – this can even lead to forced sales of holdings for other types of fund – but an investment trust’s closed-ended structure provides insulation from such uncertainty.

There are no guarantees – and it’s worth saying that the stellar performance of defence stocks over the past 18 months or so may be difficult to sustain. Shares in some defence companies have more than doubled in value. Still, in these dangerous and worrying times, funds invested in the sector may feel there is plenty of upside to come.