Rolls-Royce and BAE Systems are the two largest holdings in the iShares Europe Defence ETF (LSE:DFEU). Therefore, this exchange-traded fund (ETF) could be a perfect way to invest in these FTSE 100 stocks without having to choose one or the other.
Let’s take a closer look at the fund to see what else it offers investors.
What’s going on with defence shares?
It has been a strange period for defence stocks, as they’ve been sliding lower despite the war in Iran heating back up. BAE, for example, is now over 7% lower than it was at the start of the week.
The iShares Europe Defence ETF itself is down 16% since January.
At first glance, this makes no sense. If the wars in Iran (and Ukraine) are sadly carrying on, shouldn’t these names be hitting fresh new highs?
One issue is that investors have made solid gains from this sector in recent times. So there could be a natural rotation into other areas that are hotter or perceived to be more attractive from a valuation perspective.
More specifically, the Strait of Hormuz is effectively blocked again after the collapse of recent diplomatic agreements. Trump has threatened to hit Iran “20 times harder“.
As a result, inflation is likely heading higher and interest rates could even go up. The UK’s 10-year government bond yield has just spiked to its highest level in four weeks.
Debt interest payments already cost the UK around £110bn a year (more than the entire defence budget). Where will the UK get the extra billions needed to satisfy defence chiefs and the US government?
This week’s NATO announcement of tens of billions of dollars in defence agreements did little for most European defence stocks.
Stepping back
This is not to say that NATO defence spending isn’t going higher — it is and it will. But the market now seems to be separating which European defence contractors might win or lose from the known spending plans.
I think this backdrop makes the defence ETF even more attractive. Beyond Rolls-Royce and BAE, it holds Rheinmetall, Thales, Leonardo, Saab, Dassault Aviation, and Airbus. Each of these will benefit to varying degrees from higher European defence spending, but investors don’t need to pick winners with this fund.
The ETF also reinvests dividends, which should be materially higher in this sector in a decade’s time. So there’s an attractive compounding element here too.
As for risks, there’s obviously a lack of diversification in terms of sectors. If defence stocks remain out of favour moving forward, then the ETF will underperform.
Individual issues at Rolls-Royce and BAE would also be a drag on performance.
Attractive opportunity
Looking ahead, however, the investment case for the defence sector remains compelling, in my view. The ongoing Middle East turmoil points towards Gulf states beefing up their security, which should benefit the likes of BAE.
As Mediobanca Research points out, the conflict “further reinforces the need for stronger air defence capabilities and sustained military spending across the Middle East, supporting medium-term order intake for defence contractors with exposure to the region“.
Weighing things up, I think this ETF is worth considering while it’s down 16%. Ongoing charges are low, at just 0.35%.
Should you invest £5,000 in iShares Europe Defence UCITS ETF EUR Acc right now?
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Ben McPoland owns shares in BAE Systems and Rolls-Royce.
