Inside ETFs: Can your portfolio win the arms race?

The defence boom is here, but is there still ammunition left for your portfolio? This is Inside ETFs and we're talking about defence. The world is rearming. Governments are committing more than $2 trillion to military spending. Europe is ramping up defence budgets at the fastest pace since the Cold War. And defence companies are facing a once-in-a-generation opportunity. Budgets are exploding, orders are rising, but can defence stocks still hit the target for investors? Well, let's ask Tom Bailey, Head of Research at Han ETF. So Tom, you've just launched a new US defence ETF, giving investors exposure to companies benefiting from the world's largest defence market. So what's your pitch? What sets your fund apart in an increasingly crowded space? When we look at defence, obviously the focus has been on Europe the past few years. So we've seen a proliferation of global and European defence ETFs. But what's lacking in Europe was actually US-focused. And I think this is important because something big is happening in terms of US defence spending now. So the budget proposed for 2027 is $1.5 trillion. So that's a 50% increase compared to the previous year. And obviously, that represents around $400 billion itself. So the total budget being $1.5 trillion, with $400 billion increase. Now, that increase alone is more than the entire spend of Germany, Italy, France, and the UK in 2025. So this is a huge amount actually being spent. And at the same time, the way US defence spending is working is changing. We're seeing more focus on some of the smaller or mid-cap names in the defence space, away from the primes, although the primes do remain important. And then also, we're seeing the increased focus on next generation defence capabilities, most notably drones, but also stuff like hypersonic missiles. So we think this is a big opportunity in US defence companies right now. And so that's what we try to do. I create a product to capture that. Well, more than a fifth of exhibitors at this week's Farnborough International Air Show are first-time participants. So does that tell us the future of defence is being shaped by start-ups? And how can investors capture that? When it comes to ETFs, you can't necessarily include private companies particularly easily, particularly not in Europe. But what we've done with ETF is try to accommodate this kind of changing picture of the defence sector and the more important role that some of these smaller companies are playing. So what we've done is we've capped all constituents at 5%. At rebalance, and we rebalance four times a year. So each rebalance, we're bringing those constituents down to a maximum of 5%. And what that means is you underweight slightly those primes, those established defence companies, and you give a better representation to the smaller mid-cap names. And then at the same time, because we're seeing all this private sector, private market defence interest, a lot of these companies are eventually going to come to public markets. And we want to make sure that they're added to the ETF as quickly as possible. So what we've done with this ETF is we've added a IPO acceleration mechanism. So as I mentioned, we rebalance the ETF four times a year. But companies which come to public markets and meet all the required liquidity and market cap requirements can be added outside of that cycle. So we're adding those companies which may or may not come to public markets as quickly as possible. We've talked a lot about the US and let's stick with European defence though. It does have ambitious plans, but the delayed IPO of KNDS highlights some investor caution. So is Europe overplayed or is the rearmament story just too big to ignore? I don't think it's overplayed. I think investors have taken this idea that the Ukraine war is going to potentially come to some sort of conclusion, and therefore that means that Europe's defence spending commitments are going to ease up. We don't think that's the case. I mean, we saw at the NATO summit relatively recently all these different contracts announced and that Europe is obviously still under maximum pressure from the US administration to keep spending. And the idea that if Russia's full-scale invasion were to conclude in the coming future, that now Europe would be able to just sit back and go back to the way it kind of treated defence in the 2000s or the early 2010s just doesn't seem to us very likely. We think these big spending commitments are here to stay, and we do think we're in a new geopolitical environment where spending does have to increase. And then within that, this new geopolitical environment isn't just about simply getting budgets up to where they should be. At the same time, when you're in these sort of geopolitical environments, what you see is this very quick innovation cycle when it comes to defence. And we've seen that particularly in drones. And so this requires sustained investment in the R&D side of defence to ensure that countries are equipped properly for this less stable and more unpredictable world. So Tom, let's finish with drones here. Many of the stocks remain small, volatile and driven by headlines. So what needs to happen for drones to become a more sustainable investment? Drones are made to be expendable. You don't develop drones to last for decades. They have to be expendable. You have to be able to deploy them at scale and to absorb losses on those drones. And therefore, they have to be replaced rapidly. And I think this is kind of what's driving that potential direct funding of those drone companies to allow them to expand that production capability so the US does have a credible drone defence production base. And it wouldn't be the first time the US has done this. When you look at Alfre Harris, the US defence prime, they received a billion dollar investment from the administration to expand their missile production capabilities, which obviously is another area where obviously lots of conversation around the capability to produce more there. So I think that's kind of crucial is seeing this real credible support to actually scale up these drone companies and allow them to actually become meaningful manufacturers and contributors to the defence needs of the US or other NATO allies.