EQM Indexes CEO on Why Cybersecurity is Key to the Future of Defence ETF

Jane Edmondson, CEO of EQM Indexes, delves into the distinct features that set the Future of Defence UCITS ETF [NATO] apart from its competitors in an exclusive Q&A with OPTO. EQM Indexes is the provider for the Future of Defence UCITS ETF [NATO], and Jane Edmondson is the product manager of this ETF. Here is what she told us: 

1.What’s the objective of the Future of Defence UCITS ETF [NATO], and what exposure does it provide to investors? 

“The world has entered a new period of geopolitical instability and as a result defence spending, both hardware and cyber focused, has risen and is set to rise further. The Future of Defence UCITS ETF [NATO] provides exposure to this growth but restricted to companies within the NATO and NATO+ alliance. This is for two reasons, first to try to ensure we are providing exposure to geopolitically responsible actors. The second is that many NATO members have underspent on defence since the end of the Cold War – but that is rapidly changing given the geopolitical outlook. We believe that NATO’s resolve has never been stronger as demonstrated by its commitment to spending and modernising its defense capabilities, along with the recent addition of Finland and Sweden as member countries this year.”

2.How does the ETF track the EQM Future of Defence Index, and what are the criteria for including companies in the index? 

“The NATO ETF brings two components of modern defence together, capturing both – provides exposure to growing conventional military budgets and the rising need for robust cybersecurity and defence technologies. Using a passive, rules-based approach, companies must derive more than 50% of their revenues from the manufacture and development of military aircraft, defence equipment, and/or defence technology or have business operations in cyber security contracted with a NATO+ member country. 

On the military hardware manufacturers side, Rheinmetall [RHM] is a good example. It is a German firm focused on the design and manufacture heavy of vehicles and equipment for the German military and allied nations. It also has joint ventures with other NATO suppliers with plans to manufacture inside Ukraine.  

On the cybersecurity side, Palantir Technologies [PLTR] is a good example. The US Software company recently signed a three-year, $91.39 million deal with the UK’s Ministry of Defence. Cisco [CSCO], Fortinet [FTNT], Palo Alto [PANW] and Splunk [SPLK] are also in the index. These companies recently established agreements the NATO Communications and Information Agency (NCI Agency).”

3.Could you elaborate on the importance of cyber defence in the 21st century and how it impacts the defence investment landscape? 

“In the 21st century, national security is not just about physical borders and military strength. Governments now must consider safeguarding cyberspace, which has become a new battleground along with air, land, and sea. Indeed, in recent years notable Russian leaders such as Chief of Staff of the Russian Army Valery Gerasimov have pushed ideas around hybrid warfare in which cyber attacks play a role. 

In this new situation, cyber defence and spending is becoming more vital among NATO members. At the latest NATO summit in Vilnius, cybersecurity was once again recognised as a core area of focus. NATO noted Russia’s “malicious cyber activities” and the need for NATO to enhance its own tools.”

4.With that context in mind, how do you expect that to impact companies across the defence value chain? For instance, will more traditional sectors such as manufacturing benefit from cybersecurity growth?

“While there is a proliferation of smaller cybersecurity focused companies that are playing a role in providing critical cyber defence, the big traditional defence companies are also getting involved. For example, while BAE Systems [BA] may be more known for its leading role in weapons systems, but it also has a cybersecurity focus. This includes products and services spanning security testing, incident response, designing and building national level cyber defence capability and the security management of enterprise networks.”

5.How does the ETF accommodate for a volatile geopolitical environment, and evolving cybersecurity threats? 

“We tend to think that usually a rules-based index approach is better than active management. Using screens or rules, the index selects a broad range of companies potentially set to benefit from the trend identified. An active manager will be more focused on finding the potential winner among such group of companies. That adds potential idiosyncratic risk. With an index approach the investor gets exposure to a diversified basket of companies that tap into the theme identified.”

6.According to the Financial Times, only seven of NATO’s 31 members met the alliance’s self-imposed defence spending target of 2% of gross domestic product last year. If they all did, total outlays would rise by more than $150bn a year. What would this mean for the ETF and its holdings? 

“If, or when, NATO members start to actually meet or exceed the 2% spending target, this potentially means more orders for defence equipment. The crucial part of the spending target, however, is the second commitment of NATO members to spend at least 20% of this on new equipment and R&D to ensure the alliance can keep its technological edge and modernise its capabilities. It is that number that the ETF’s holdings will be tapping into rather than extra spending on, for example, personnel.”

7.Has the ongoing Russia-Ukraine conflict emphasised the dawn of a new age in modern warfare? 

“The war in Ukraine has done away with the idea that modern conflict will be limited to counterinsurgency campaigns, as had been the case in the first two decades of this century. We are, unfortunately, seeing the potential development for a new kind of high intensity war that combines cutting-edge tech with large amounts of manpower and industrial-scale munitions consumption. 

So, two lessons: First, militaries that fail to invest in new technologies will potentially be at a disadvantage to smaller ones that do. Second, militaries must ensure huge stockpiles and be able to manufacture hardware at much greater scale. 

At the same time, states must become increasingly focused on their cyber capabilities. Battlefields are now blanketed with sensors, satellites, and drones. Lack of cyber capabilities can prove disastrous in this context. 

But it’s not just about direct participants in conflict. Since the full-scale invasion of Ukraine in 2022, state-sponsored actors have targeted 128 governmental organisations in 42 countries that support Ukraine. Allied countries and private companies within those countries also face cyberthreats.”

8.In light of the rapidly evolving global security landscape, how does the ETF adapt to potential changes in NATO and NATO+ ally spending patterns?

“Each quarter the index is rebalanced to ensure we are reflecting any changes that may have occurred within the defence and cyber themes. The other important aspect of the index here is that it caps single stocks at 5%. This ensures that smaller companies in the space are represented. Alongside the big names, a new cohort of private firms will also be crucial in the age of defence we are seeing, so this ensures not letting the big firms crowd these out. We also have a single-country screen. This means that no single country can account for more than 60% of the total weighting. In practice, this means not letting the US crowd out other countries Some European states, after all, are focused on building up their own defence industries.”  

9.What sets the Future of Defence ETF apart from competitor funds focused on the defence sector and cybersecurity, such as the VanEck Defense UCITS ETF [DFNS]?

“We think the ETF has several vital USPs. First of all, we use a screen to only include companies that are domiciled in NATO or NATO+ countries. The NATO Alliance was set up to defend the democracies that emerged after the Second World War from potential Soviet aggression. NATO, we believe, still provides this defensive role, albeit against new threats. That’s why we believe it is important to try and only provide exposure to NATO or NATO+ countries – we believe it is a potential way to ensure we are providing exposure to responsible geopolitical actors. The other USP is our greater weighting toward cybersecurity than other defence ETFs may have. As I’ve noted, cybersecurity is an increasingly vital domain of defence in the 21st century, so we wanted to ensure it was well-represented. We also believe it provides a more diversified exposure due to the different characteristics of stocks found within this space.  Finally, another distinction between NATO and DFNS is the ESG screening process. NATO does not exclude “controversial weapons” whereas some other ETFs do. We found that screening out controversial weapons eliminated too many large defence players that were essential to this theme, so we opted for a lighter UNGC and OECD Principles Violation screening process.”