Is it appropriate to include defense stocks in an ESG portfolio? A significant and divisive trend appears to be emerging.

• The ongoing war in Ukraine has caused a significant change in how defense stocks are perceived by mission-driven fund managers, as stated by two European defense companies.
• As geopolitical risk rises, governments are increasing defense spending and profits in the industry are soaring.
• Nonetheless, the idea of including defense stocks in sustainably-minded portfolios remains controversial.

The ongoing war in Ukraine has caused a significant change in the perception of defense stocks among mission-driven fund managers, as stated by two major European defense companies.

Historically, defense stocks have been omitted from portfolios due to ethical concerns about their connection to warfare, despite ESG considerations.

In recent months, ESG fund managers have become more comfortable investing in defense companies, as industry profits and defense spending rise in response to increased geopolitical risk.

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

The CEO of Saab, Micael Johansson, stated that the Russian invasion of Ukraine in February 2022 caused a significant shift in the ESG discussion.

Before the tragic war, we had approximately 45,000 to 50,000 shareholders, but now we have over 175,000. Although the interest in investing in us has changed, there is still some hesitation in the market, as Johansson explained to CNBC's Silvia Amaro on Aug. 21.

Some pension funds are still hesitant to invest in defense stocks, according to Johansson. He noted that there hasn't been a sudden shift in recognizing defense firms as sustainable businesses.

Johansson stated that not everyone sees the issue in the same way, and there is still work to be done in that area, which is frustrating because without security and a deterrent effect, it is difficult to discuss ESG from other perspectives. In Johansson's view, this is the foundation of sustainability.

The value of Saab shares, which manufacture missiles, submarines, and fighter jets, has increased by approximately 330% since the start of Russia's conflict with Ukraine, from February 20, 2022 to August 29, 2024.

'I don't have any problem with our reputation'

Ida Kassa Johannesen, head of commercial ESG at Saxo Bank, stated via videoconference to CNBC that traditionally, ESG investors, particularly retail investors, avoid being linked to companies that manufacture weapons.

"These are companies that cause the death of innocent victims in the Middle East, Africa, and other parts of the world through wars. Retail investors are avoiding these types of companies."

Fund managers have historically been hesitant to include defense stocks in their portfolios to avoid facing scrutiny from their clients, as stated by Johannesen.

Saab's Johansson responded to the question about defense firms' need to improve their reputation by stating, "Perhaps, I'm not sure. However, I believe I wouldn't have spent 39 years working for this company if I wasn't deeply committed to our mission, values, and the contributions we make to resilience and excellence."

If defense forces require resources, it is crucial to have professional and serious companies capable of delivering them, according to Johansson.

He stated that he supports our mission, which is crucial, and he has no issue with our reputation. He also mentioned that he is unsure about how others feel about it.

'Big villains' vs. firms that are 'not that bad'

The topic of ESG investments has sparked intense political debates in the U.S. in recent years.

Republican politicians have characterized mission-oriented investments as a type of "woke capitalism" that prioritizes liberal objectives over financial gains.

The Democrats' Committee on Oversight and Accountability has stated that attacks on ethically responsible business practices are an attempt to create a culture war and protect corporate special interests, as described by democratic lawmakers.

The U.S. presidential election in November will determine whether the political backlash against ESG will have a profound and enduring impact.

Brad Greve, chief financial officer at British defense group, stated in an interview on Aug. 14 that it was impossible to have conversations about doing great things across the E, S, and G before the Ukraine conflict.

Since the events in Ukraine, there has been a significant shift in perspective. I believe that individuals have now taken the time to reflect on the importance of defense companies in safeguarding a democratic society.

While fund managers have the freedom to invest as they see fit, Greve believes that it is beneficial to have discussions about the positive impact they can have on society.

The stock price of BAE Systems, a company that produces nuclear-powered submarines, fighter jets, and munitions, has increased by approximately 130% from February 20, 2022 to August 29, 2024.

While Russia's ongoing war with Ukraine has sparked discussions about ESG, most fund managers remain "cautious" about investing in the defense sector, according to Saxo Bank's Johannesen.

Should we group all defense companies together? The reality is that it's a diverse mix. It's actually a collection of various types of companies. There are some bad actors and others that are not so terrible, according to Johannesen.

"It's not easy to label someone a villain just because they produce weapons. It's not my place to decide, and I believe retail investors should make their own choices. However, they should not try to demonize all companies that produce weapons, such as those involved in defense," she stated.