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ESG Fund Trounces Peers Helped by Bold Bet on Defense Stocks

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(Bloomberg) -- An ESG fund run by Alken Asset Management Ltd. has outperformed 98% of its peers over the past year, helped by a bet on European defense stocks while they were still cheap.

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The Alken Fund Sustainable Europe (ALCSEU1 LX) is up about 9% in the period, compared with an average drop of roughly 9% among similar funds, according to data compiled by Bloomberg. Aside from defense, which represents about 8% of the portfolio, the fund’s gains were driven by its exposure to energy and raw materials.

London-based Alken, which oversees about 1.5 billion euros ($1.5 billion) in total, is the latest example of an investment manager offering outsized ESG returns by betting on industries that aren’t generally associated with environmental, social or governance goals. Alken’s Sustainable Europe fund, which is registered in Luxembourg, qualifies as a so-called Article 8 product under European ESG rules, meaning it “promotes” sustainability.

After years of under-investment, Europe’s defense sector was undervalued and poised to “benefit massively” from the current political climate, Nicolas Walewski, founder of Alken Asset Management and co-manager of the firm’s Sustainable Europe fund, said in an interview.

Alken started buying defense assets in the middle of last year, Walewski said. He and his team were “surprised” that others weren’t doing the same, but more investors then “actually jumped in fairly quickly in March and April,” he said. The portfolio is overweight industrials, with its exposure to defense stocks including companies like Thales SA, and to the energy sector.

Ukraine

When it comes to ESG bets, defense stocks are about as controversial as it gets. The weapons industry has this year embarked on an intense lobbying campaign urging European lawmakers to label such assets as sustainable, and points to the West’s race to arm Ukraine to underpin its case.

But ESG purists argue that treating tools ultimately designed to kill as sustainable assets would be a slap in the face of everything that ESG is supposed to stand for. And with the arms industry “responsible for millions of deaths,” ESG data cruncher Util has characterized the whole idea as misguided.

According to a July 12 report by analysts at Goldman Sachs Group Inc., ESG fund ownership of aerospace and defense stocks overall was lower in June compared with October last year as managers went more underweight.

Walewski said it’s wrong to rule out defense stocks as sustainable assets in the current geopolitical climate, in which authoritarian regimes are growing increasingly belligerent toward Western democracies and their allies.

“We have to defend our countries,” he said. “You don’t defend your countries with flowers.” Which sectors should be treated as ESG is “open to debate. Finance is investing where the money is. Sometimes the money is in tech, sometimes it’s in defense.”

Investors that bought European defense stocks well before the war in Ukraine have enjoyed considerable gains over the past year. Rheinmetall AG, one of Germany’s biggest arms manufacturers, is up almost 120% this year alone as Chancellor Olaf Scholz recasts his country’s post-World War II policy with an historic arms spending spree. French defense company Thales has gained about 60%.

There’s been a “wake-up call,” Walewski said. Other Article 8 funds “do invest in conventional weapons, some even in controversial ones.” Alken is just saying out loud “what everyone is doing in the shadow, exposing ourselves to critics,” he said.

The Alken fund, which has avoided all exposure to so-called controversial weapons such as cluster munitions, has in the meantime trimmed its exposure to defense somewhat. But Walewski said he expects the sector to remain attractive. “Of course they’re not going to outperform by 100% every six months, but we still think the long-term future is bright.”

“It will take years for these companies to keep up with the demand,” he said. “The world is unsafe.”

Goldman Sachs’ basket of European stocks with exposure to defense spending, which includes Rheinmetall, Thales and BAE Systems Plc, is up 58% this year, compared with a 13% decline for the benchmark Stoxx Europe 600 Index. Meanwhile, sectors that have traditionally been ESG darlings -- such as tech -- have slumped in 2022, with the MSCI World Information Technology Index down about 24%.

“Defense is good. It’s very sustainable,” Walewski said. “We’ve just rediscovered that.”

The Sustainable Europe fund that Walewski co-manages revamped its investment approach a few years ago and now pays much closer attention to any warning signs that a company might be hit by potential governance issues. That’s after being burned by its stake in German electronic payments provider Wirecard AG, which collapsed in 2020 after becoming embroiled in an accounting fraud scandal. The company made up around 10% of Alken’s Sustainable Europe fund at one point. The asset manager has sued Wirecard.

Fossil Fuels

The fund’s embrace of energy stocks has been a major driver of returns, with the sector being the best performing subgroup in the Stoxx Europe 600 Index this year. Alken targets companies that invest a “significant part” of their capital spending on the energy transition.

“That’s the best way to be a sustainable fund,” Walewski said. He also sees hydrocarbons as an essential part of the world’s power supply for decades to come. “It’s unsustainable not to allow us to satisfy 80% of our energy needs for at least the next 10, 15 years.”

“We cannot increase the speed of renewables in the global energy mix that much,” Walewski said. “It will remain a moderate part of the global energy mix for a very long time. Not 2, 3 years -- a very long time. 20, 30 years at least.”

(Adds share of fund made up by defense in second paragraph; also adds more references to energy and raw materials)

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