Defense stocks in an ESG portfolio? A profound — and controversial — shift seems to be underway

Russia's ongoing war in Ukraine has resulted in a profound shift in the way defense stocks are viewed by mission-driven fund managers, according to two European defense giants.

Defense stocks have typically been excluded from portfolios based on environmental, social and governance (ESG) factors due to ethical concerns over their association with warfare.

In recent months, however, ESG fund managers appear to have become increasingly comfortable with holding defense companies — at a time of soaring industry profits and higher defense spending, as governments respond to elevated geopolitical risk.

Nonetheless, the inclusion of defense stocks in sustainably-minded portfolios remains controversial.

Micael Johansson, CEO of the Swedish defense and security company Saab, said Russia's decision to launch a full-scale invasion of Ukraine in February 2022 had brought about a "dramatic" change in the ESG debate.

"I think we had, like, 45,000 to 50,000 shareholders before this tragic war happened and now, we have, like, beyond 175,000 shareholders. Of course, the interest in investing in us is very different now, but there is still some sort of hesitation in the market," Johansson told CNBC's Silvia Amaro on Aug. 21.

Johansson said some pension funds, for example, were still unwilling to invest in defense stocks, adding that there hasn't been a sudden "all-in" approach to recognizing defense firms as sustainable businesses.

"Not everyone is viewing it that way. There is still more to do in that area, which is to me really frustrating … because if you don't have any security and a deterrents effect, then you can't talk about the ESG from other perspectives. That's sort of the foundation of sustainability in my eye," Johansson said.

Shares of Saab, which produces missiles, submarines and fighter jets, have skyrocketed since the start of Russia's war with Ukraine — up around 330% between Feb. 20, 2022 and Aug. 29, 2024.

"Traditionally, ESG investors and especially retail investors do not want to be associated with companies that produce weapons," Ida Kassa Johannesen, head of commercial ESG at Saxo Bank, told CNBC via videoconference.

"Ultimately, [these are] companies that cause the death of people [and] innocent victims in the Middle East at the moment, in wars waged in Africa, for example in [the Democratic Republic of the] Congo, and a few other places in the world. Retail investors just do not want to have anything to do with these types of companies."

As a result, Johannesen said that fund managers have typically been reluctant to include some defense stocks in their portfolios in order to avoid being questioned by their clients.

Asked whether defense firms may have more work to do to improve their reputation, Saab's Johansson replied: "Maybe, I don't know. I think I wouldn't have worked 39 years for this company if I hadn't been extremely committed to what we do, and what we actually stand for, and what we contribute with in terms of resilience and great capabilities."

Johansson said that, if politicians recognize a threat environment, then it is imperative to have "professional" and "serious" companies capable of delivering the necessary resources to defense forces.

"So, we stand for something really important — and I don't have any problem with our reputation. I don't know about others," he added.

ESG investments have become a polarizing political issue in recent years, particularly in the U.S.

Republican lawmakers have labeled mission-driven investments as a form of "woke capitalism" that seeks to prioritize liberal goals over financial returns.

Democratic lawmakers have sought to push back, describing attacks on a range of ethically responsible business practices as "an attempt to manufacture a culture war and protect corporate special interests," according to the Democrats' Committee on Oversight and Accountability.

Analysts expect the outcome of the U.S. presidential election in November to determine whether the political backlash against ESG will have a deep and lasting effect.

"You couldn't even have those conversations pre-Ukraine because even though you might be doing great things across the E, the S and the G. You couldn't even talk about it," Brad Greve, chief financial officer at British defense group BAE Systems, told CNBC in an interview on Aug. 14.

"What's happened since Ukraine, there has been a real change in attitude. I think people have now reflected. It's really important that we see the role that defense companies play in protecting a free society," he said.

Greve noted that while fund managers will always have the right to invest as they see fit, "what's good now from my perspective is that we can have these conversations about the role we the positive role we play in society."

Shares of BAE Systems, which makes nuclear-powered submarines, fighter jets and supplies munitions, have climbed roughly 130% over Feb. 20, 2022 to Aug. 29, 2024.

Share performance of BAE Systems from Feb. 20, 2022.

Saxo Bank's Johannesen said that, while Russia's ongoing war with Ukraine had stoked the ESG debate, most fund managers remain "pretty cautious" about investing in the defense sector.

"Should we all put [defense companies] in the same basket? The truth is it's a mixture. It's really an assortment of a different type of companies. You have big villains and then you have those that are, I would say, not that bad," Johannesen said.

"It's not easy to say, because you produce weapons, you are a villain. It's not for me to decide, and I think retail investors should not decide for everybody else. They should decide for themselves — but they should not try to demonize all those companies that produce weapons, for example," she added.