(Bloomberg) -- In the world’s biggest ESG fund class, portfolio managers are getting more comfortable with holding military assets against a backdrop of mounting political pressure and industry profits.

At the end of the third quarter, 1,238 funds claiming to “promote” environmental, social and good governance goals held stocks in the industry classification code Aerospace & Defense, according to Morningstar Inc. data. That’s roughly 25% more than in March last year, right after Russia invaded Ukraine. A large portion of those funds converted to “ESG” during the period, Morningstar said.

The development is playing out amid a campaign to get ESG investors to support Europe’s military capability, as geopolitics in the wider region become increasingly fraught. Alexander Stafford, chair of the UK All-Party Parliamentary Group on ESG, told Bloomberg that “the violence” that’s followed the “invasion of Ukraine has cemented to me the ESG case for defense-related investment.” 

And within military circles, investing in weapons is being held up as the ethical thing to do. Last month, NATO Secretary General Jens Stoltenberg called for more money to be allocated to weapons, arguing that there’s “nothing unethical about defending our freedom.”

Yet the issue continues to divide ESG investors. And the war between Israel and Hamas has underlined what’s at stake, as the world looks on in horror at the growing list of civilian fatalities. 

Identifying whether investments are being deployed for defense or aggression is “a very difficult due diligence to undertake,” said Sonali Siriwardena, global head of ESG at law firm Simmons & Simmons. Ultimately, “it’s a question of how do you ensure that these investments are being used for a defensive purpose as opposed to indirectly contributing to offensive action.”

Sasja Beslik, chief investment strategy officer at SDG Impact Japan, says it’s hard to claim that investments in defense are aligned with the United Nations’ 16th Sustainable Development Goal, which targets peace, justice and strong institutions. 

“I have no problem with people investing in weapons companies or stock, but don’t do it under the sort of umbrella of ESG or sustainability, because it’s not,” he said. “These are products that kill people.”

While the world’s largest ESG fund class is more exposed to defense assets now than in March 2022, it’s a different picture in other corners of the industry. 

In the EU’s smallest — and strictest — ESG classification (known as Article 9), funds are retreating from defense assets. And among funds that claim to be “promoting” ESG — known as Article 8 — the rise in exposure to defense stocks still only leaves such holdings at 0.44% of total assets, which Morningstar puts at about $5 trillion.

Morningstar also points out that much of the increase in the number of Article 8 funds holding defense assets comes after the fund class absorbed a wave of upgrades from a non-ESG fund portfolio category known as Article 6.

James Penny, chief investment officer at TAM Asset Management and an ESG investing veteran, said the issue remains “very difficult.” 

“On the margin, I would still agree with the assertion that these aren’t ESG companies and I’d feel quite comfortable putting that into our portfolios as a red line,” he said. 

Jens Munch Holst, chief executive at Danish pension fund AkademikerPension, said his red line starts at producers of controversial weapons, such as cluster munitions and nuclear arms. But after that, the fund is open to investing in defense companies that demonstrate good governance and good returns, he said.

AkademikerPension holds SAAB AB, which makes the Gripen fighter jet, and Kongsberg Gruppen, which recently sold a coastal missile system to Poland to help it bolster its defenses against Russia. 

“The defense industry lives fine without our investments,” he said. “We don't think it's credible that we would be able to influence them on the products they sell, and especially when it comes to nuclear weapons."

Funds building up their exposure to the defense sector are enjoying considerable price gains. A Goldman Sachs Group Inc. basket of European stocks exposed to defense has climbed about 13% since the first week of October, and is up almost 90% since late February 2022.

James Alexander, chief executive officer of the UK Sustainable Investment and Finance Association (UKSIF), said he’s not aware of any regulatory restrictions preventing ESG managers from holding defense assets (save for controversial weapons). The main requirement is that funds provide “transparent, high-quality reporting,” he said.

Funds classified as Article 8 “can hold any security from any sector,” said Hortense Bioy, global director of sustainability research at Morningstar. Even for the stricter Article 9 ESG fund designation, European regulations leave “too much room for interpretation,” she said.

Legal & General Investment Management, the UK’s biggest fund manager, is among firms that include Aerospace & Defense stocks in its Article 9 offering. 

“There is no reason in principle why investing in certain defense companies can’t be consistent with responsible investing, as long as they’re not producing controversial weapons or providing conventional arms to high-risk countries,” LGIM said in an emailed statement to Bloomberg. “As a fiduciary, we will continue to cater to different client needs and preferences across our range of funds and solutions” and “we believe that countries have an inherent right to self-defense.”

The defense industry has been lobbying hard in Europe to persuade officials to consider including weapons in the bloc’s official list of designated sustainable activities. The EU only just put the finishing touches on its green taxonomy, and has delayed work on a social chapter, in part due to the intense controversy surrounding the subject.

In a letter sent to the European Commission in June, a Czech EU lawmaker representing the chamber’s center-right European People’s Party said the EU was “inadvertently” weakening defense companies “by not including them within the realm of sustainable finance.”

In a response sent three months later, the EU’s commissioner for financial services and markets, Mairead McGuinness, appeared to offer some support for the industry’s position.

The EU’s executive arm “acknowledges the need to ensure access to finance and investment, including from the private sector, for all strategic sectors,” McGuinness said in September. Defense is “a crucial contributor to the resilience and security” of the EU, and therefore “to peace and social sustainability,” she added.

But within the EU’s many institutions, there’s considerable disagreement. The European Investment Bank has said it won’t cave in to pressure to invest in the defense industry. And a key advisory group to the EU Commission, the Platform for Sustainable Finance, has recommended against including defense assets in the EU’s social taxonomy. 

Read More: ESG Managers Skewer ‘Ridiculous’ Idea of Embracing Arms Stocks 

McGuinness has stressed, however, that the EU Commission isn’t bound by such advice. She also noted that the bloc’s existing sustainable finance framework “doesn’t impose any limitations to financing any specific sector.”

--With assistance from Lisa Pham.

(Adds fund comment in 16th paragraph)

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