In response to the HM Treasury and IA joint statement on defence investment

[Read the HM Treasury and IA statement here]

A curious 81-word statement was released this week by HM Treasury and the Investment Association.  Together, they announced that “investing in defence companies contributes to our national security, defends the civil liberties we all enjoy, while delivering long-term returns for pensions funds and retail investors”.  The statement also noted that “investing in good, high-quality, well-run defence companies is compatible with ESG considerations as long-term sustainable investment is about helping all sectors and all companies in the economy succeed”.  The trouble is, sustainable investment is not about this at all.  And the debate about whether to invest in or divest from defence companies is not one of “ESG considerations”.  It’s a question of ethics.  

The concept of sustainable investment exists as part of our capitalist markets.  By definition these markets are built on the assumption that some companies will thrive and others will fail.  This is true across sectors, asset classes and geographies.  Sustainable investment is not about “helping all sectors and all companies in the economy succeed”, because investing is not about helping all companies in the economy succeedRather, all investing, of which sustainable investing is a subset, is about how to allocate capital based on defined criteria.

Such criteria may differ between funds; the fact criteria differ is what creates a marketplace of opinions (the stock “market”).  “Fund A” may decide to invest in renewable energy companies in order to support the development of clean energy; “Fund B” may define its sustainable investment criteria as investing in transition assets, for example oil majors that are transitioning away from the dirtiest of the fossil fuels.  Both approaches are valid, if their definitions are explained correctly (something the FCA has made clear in its soon to be launched Sustainability Disclosure Requirements, “SDR”, regime).

The crucial point, however, is that such funds will not invest to help all sectors and companies within an economy: indeed, the success of all actively managed investment funds relies on them being able to identify companies that thrive over the long-term and avoid those that don’t.  The market demands both winners and losers in order to function and for capital to flow across an economy.

Rather, it is the role of governments, regulators and to some extent trade bodies, to provide frameworks and regulatory systems that can offer all companies and sectors the opportunity to thrive.  The market will then determine where potential is realised.

On to the second problem with the statement.  Ever since Russia’s invasion of Ukraine, it has become de rigueur to debate the merits of including the defence sector in “ESG Funds”.  But as noted in my introduction, the aversion of some investors to this sector is not about ESG.  Environmental, Social or Governance factors should be analysed whenever you are considering an equity investment (so we believe at Montanaro) because this helps to build up a more complete picture of the risks and opportunities facing a company.

Any investor considering a defence company within a portfolio should analyse the company’s environmental footprint; its social profile; and its governance strengths and weaknesses.  An investor may choose not to invest in a defence company because of an ESG weakness, for example a high carbon intensity, or poor governance (certain defence companies have, over the years, been embroiled in social and corporate governance scandal).

Choosing to forgo the entire sector, however, would be an ethical choice, not an ESG decision.  This is an important difference, but one the statement entirely misses, and one that does cause confusion generally across the responsible investment space (being charitable, if the Treasury appears confused by the nuances around Ethics/ESG/sustainable investment terminology I suppose it is no surprised many others are too).

For decades, some investors have excluded sectors from their investment universe on ethical grounds.  Ethical perspectives can differ from person to person and from institution to institution.  Most people understand why a religious investment body might ban certain sectors that are incompatible with its world view, for instance.  Given that sanctity of life exists at the heart of major world religions, it is understandable why defence is often an excluded sector for religious investment groups.  It is also reasonable that some investors choose to shun “controversial weapons” (anti-personnel landmines, cluster munitions, chemical, biological and nuclear weapons) and others avoid the sector for the simple reason that defence weapons are also used in attack – and weapons sold by defence companies may not always end up in the hands of those supporting your own civil liberties.

A sector restriction based on an ethical view does not mean that you wish that industry to be wiped from the face of the earth.  At Montanaro, we have an exclusion on alcohol manufacturing as we are concerned that certain sales practices in the sector target societies’ most vulnerable.  We do not, however, wish for a return to prohibition. Rather, restrictions signify that with the limited amount of capital at your disposal, you are not willing to invest in certain areas of the economy where the negatives, in your view, outweigh the positives.

Understood this way, ethical choices can support a sustainable investment mandate.  Returning to the example of “Fund A”, it would make sense for a renewable energy fund to have a ban on investing in companies that derive more than a certain percentage of revenue from fossil fuels.  This provides clarification to the Fund’s objective and reassures investors.

This is not to say that the debate about defence is unwelcome.  There are nuances to ethical dilemmas, which is why ethics has exercised some of humanity’s greatest minds over the aeons.  Take plastics, where a debate is currently raging between the UN, which is trying to cap the production of plastics, and petrochemicals giants such as Exxon, who are fighting the proposed legislation.  Plastic pollution is a problem, of which there can be no scientific doubt.  This does not mean, however, that all plastic is evil or should be banned.  Plastic has many important functions in the world today.  In hospitals, there are many examples where its single-use is essential to saving lives.

Unfortunately, since the statement from the Treasury and IA the newspapers have been full of headline articles proclaiming that investing in defence companies is ethical. Call me a cynic, but would this statement have been published were it not for the strong outperformance of the sector over the last year?  Have under pressure fund managers been lobbying for a change in perception for the defence sector?  Our own view is that ethical investment rules should not change with the short-term winds of market performance, or indeed politics.  This would only cause confusion to investors.

One final point.  As my colleague Adam Montanaro wrote recently on our blog, there are many pressing issues confronting the UK stock market currently, which is deeply out of favour on a global basis.  There are surely higher priorities than this for those who oversee our markets.


The views expressed in this article are those of the author at the date of publication and not necessarily those of Montanaro Asset Management Ltd. The information contained in this document is intended for the use of professional and institutional investors only. It is for background purposes only, is not to be relied upon by any recipient, and is subject to material updating, revision and amendment and no representation or warranty, express or implied, is made, and no liability whatsoever is accepted in relation thereto. This memorandum does not constitute investment advice, offer, invitation, solicitation, or recommendation to issue, acquire, sell or arrange any transaction in any securities. References to the outlook for markets are intended simply to help investors with their thinking about markets and the multiple possible outcomes. Investors should always consult their advisers before investing. The information and opinions contained in this article are subject to change without notice.

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