6 Equity Mutual Funds to Benefit from India’s Defence Sector

As per the global BlackRock Geopolitical Risk Indicator (BGRI), medium-to-high risks emanate from potential major cyber-attacks, terror attacks, tensions in the Gulf region, U.S.-China strategic competition, and Russia-NATO conflict. Even international rating agency S&P Global has highlighted these among the top 10 geopolitical risks of 2023.

Keeping a tab on the dynamic geopolitical environment, India over the last few years under the Modi-led-NDA government has made sizeable investments in the defence sector.

According to Stockholm International Peace Research Institute (SIPRI), India ranks third in defence expenditure after China and the U.S. In the Union Budget 2023, the government allocated Rs 5.95 trillion, an increase of 13% from the previous union budget. There is a clear thrust on the modernisation of India's defence capabilities.

In the previous fiscal year, i.e., 2022-23, India's defence production or turnover crossed over Rs 1 trillion for the first time ever (touched Rs 1.06 trillion), a rise of more than 12% over FY 2021-22 as per the Press Release of the Ministry of Defence. And if private firms engaged in defence industries are added, this figure is expected to be more. The number of defence licenses issued to industries in the last 7-8 years by the government have increased by almost 200%, according to the Ministry of Defence with emphasis on 'Make in India' and Aatmanirbharta (self-reliance) in defence. The Prime Minister, Narendra Modi has often stated that government will keep supporting efforts to make India a defence production hub.

The production target set by the government for India's defence sector is Rs 1.75 trillion (around USD 22 billion) by 2025. Out of that, exports would also play a pivotal role for players in the defence sectors. Last year, India's defence exports reached an all-time high of Rs 16,000 crore, which is 10x since 2016-17. Particularly over the last 5-6 years, the government has taken several policy initiatives and brought reforms to give a push to India's defence exports. From being an importer of various types of defence items eight years ago, today exports major platforms like Dornier-228, 155 mm Advanced Towed Artillery Guns (ATAGs), Brahmos Missiles, Akash Missile System, Radars, Simulators, Mine Protected Vehicles, Armoured Vehicles, PINAKA Rockets & Launchers, Ammunitions, Thermal Imagers, Body Armours, besides Systems, Line Replaceable Units and Parts & components of Avionics, and Small Arms. Plus, there is a growing demand for LCA-Tejas, Light Combat Helicopters, Aircraft Carrier, MRO activities etc. The government has set a target of USD 5 billion in defence exports by 2025.

[Read: Do General Elections Matter for the Indian Equity Markets]

Recently Iran-Israel has engaged in a military conflict, and there could be potential build-up of this in other regions of the Middle East, such as Iran, Lebanon, Iraq, Yemen, and Syria. Plus, escalations in the attacks in the Red Sea, may go on to disrupt trade and supply chains, lead to a rise in commodity prices, impact the disinflation process, and amplify the volatility in the financial markets.

Tensions are also brewing in the Korean peninsula, China is exhibiting its military prowess in the South China Sea to provoke Taiwan and the U.S., there are China-India scruffles at the border, the ongoing Russia-Ukraine war, and more.

Even while the Israel-Hamas conflict is a depressing reality for the people in the region, it offers India's defence exports a lucrative growth opportunity. Given that Israel is expected to approach its allies—the US, India, and others—to ensure enough supplies to fight the war, the escalation of this conflict could present opportunities for India's military companies in the near to medium term.

Given the above, the potential to benefit by sensibly taking exposure to defence sector stocks is huge!

With which much progress made by India's defence sector in the last 5 years, the Nifty India Defence Index - TRI (which tracks the performance of listed defence companies) has delivered substantial returns -- outperforming the Nifty 50 -TRI and creating wealth for investors. Companies that have been the beneficiaries of India's thriving defence sector, especially the missile programme and aerospace sector, plus those in naval/marine capabilities, have done exceptionally well.

As seen in Table 1, many companies in the defence sector, such as Mazagaon Dock Shipbuilders, Cochin Shipyard, and Premier Explosives, among others have delivered handsome returns since August last year. Many mutual fund schemes have held respectable exposure to defence stocks, enabling them to benefit from their rally.

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Out of a total of 267 diversified equity mutual fund schemes taken into consideration and one defence sector-specific scheme, at least 1 scheme has invested in at least one defence stock as per the portfolio as of March 31, 2024. Nine schemes have an exposure of 5% or more, 38 have an exposure of around 3-4%, 110 mutual fund schemes have an exposure between 1% and 2%, and 30 schemes have an exposure of less than 1% to defence stocks.

At the fund house level Kotak Mutual Fund, Invesco Mutual Fund, NJ Mutual Fund, and ITI Mutual Fund have a noticeable exposure to India's defence sector.

Speaking of the equity mutual fund scheme, here are the five having high exposure to defence stocks...

Recently launched, HDFC Defence Fund, which is a sector-specific scheme, currently has 65.29% exposure to defence stocks. Besides, it invests in allied companies that are in defence-related activities.

#1: HDFC Defence Fund

Launched in June 2023, HDFC Defence Fund, under normal circumstances, has the mandate to invest 80% to 100% of its assets in equity and equity-related instruments of Defence & allied sector Companies. Currently, the fund holds a concentrated portfolio of 24 stocks, wherein a majority are largecaps (42.11%) and the remaining 8.26% and 41.91% are midcaps and smallcaps.

Among the defence stocks, Hindustan Aeronautics, Bharat Electronics, Astra Microwave Products Ltd., and Solar Industries India, are among the top-5 defence stocks as of March 31, 2024. Then among the allied ones are those in the engineering and capital goods space, such as MTAR Technologies Ltd., Premier Explosives Ltd., Bharat Dynamics Ltd., and so on, which are also engaged in the defence business. Want to know the other stocks in the HDFC Defence Fund's portfolio? Visit its factsheet here.

Note, HDFC Defence Fund, after receiving a good response for its NFO and recognising that its investment universe is limited (total 24 stocks), has restricted fresh investments. This is done to preserve the overall investment strategy and safeguard the interests of current investors.

[Read: HDFC Mutual Fund Restricts Lumpsum Investments in HDFC Defence Fund. Here's Why]

#2: 360 ONE Quant Fund

Launched in November 2021 amidst the COVID-19 pandemic, 360 ONE Quant Fund (from the stable of 360 ONE Mutual Fund, erstwhile known as IIFL Mutual Fund) is a thematic fund pursuing a quant approach for its portfolio construction activity. As per its March 2024 portfolio, the fund has 9.99% exposure to key defence stocks (out of a total portfolio of 37 stocks).

The top-10 stocks comprise 38.25% of the current portfolio, and the defence stocks, such as Hindustan Aeronautics and Bharat Electronics, are very much a part of it. The overall portfolio as of March 2024 of 360 ONE Quant Fund is mainly in midcaps (51.19%) and the remaining (46.93%) in largecaps.

#3: Kotak Emerging Equity Fund

Launched in March 2007 as a mid and small cap fund, was recategorised as a mid cap fund after SEBI's recategorisation and rationalisation norms. At present, Kotak Emerging Equity Fund aims to generate long-term capital appreciation from a portfolio of equity and equity-related securities by investing predominantly in mid-companies. The fund holds a well-diversified 78 stocks in line with its investment mandate.

The top 10 stocks comprise 32.65% of the portfolio, of which Solar Industries -- a defence stock -- is one of them. The other defence stocks in its portfolio are Bharat Forge and Bharat Electronics. Kotak Emerging Equity Fund's overall exposure to defence stocks is 9.67%

By holding a robust portfolio by following a bottom-up approach to stock picking and buy-and-hold strategy, overall Kotak Emerging Equity Fund has lived up to its mandate and rewarded investors with superior risk-adjusted returns. It is one of the top performers among the mid cap funds.

#4: DSP India T.I.G.E.R Fund

Launched in June 2004, the DSP India T.I.G.E.R Fund, in line with its mandate which aims to from a portfolio that is substantially constituted of equity securities and equity related securities of corporates, which could benefit from structural changes brought about by continuing liberalization in economic policies by the Government and/ or from continuing investments in infrastructure, both by the public and private sector.

The scheme holds overall exposure of 8.525 in defence stocks. Hindustan Aeronautics Ltd. is DSP India T.I.G.E.R Fund's top defence holding also featuring in the top 10 stocks of the scheme. Overall, the fund holds a well-diversified portfolio of 73 stocks in congruence with its investment mandate of investing in midcaps. The scheme follows a bottom-up approach to stock selection to pick good and sound businesses.

#5: Edelweiss Mid Cap Fund

Launched over a decade ago in January 2013, formerly as Edelweiss Mid and Small Cap Fund, after the mutual fund categorisation and rationalisation norms was re-categorised as a mid-cap mutual fund scheme. The fund at present aims to generate long-term capital appreciation from a portfolio that predominantly invests in equity and equity-related securities of midcap companies. In line with that, Edelweiss Mid Cap Fund holds 66.94% of its equity portfolio in midcap, 13.95% in smallcaps, and the balance (17.28%) in largecaps.

The fund currently has 74 stocks in its portfolio, and the top 10 holdings comprise 33.31% of the portfolio. However, the fund holds only Solar Industries India Ltd. from the aforementioned defence stocks in the top-10 holdings. The overall exposure to defence stocks is 8.27% of its total assets.

#6: HSBC Infrastructure Fund

Launched in September 2007, this fund seeks to generate capital appreciation by investing predominantly in equity and equity related instruments of companies in the Infrastructure sector. Bharat Electronics is part of the top 10 holdings of the fund.

With 59 stocks in its portfolio and top-10 stocks comprising 38.60%, the overall equity portfolio of HSBC Infrastructure Fund is well-diversified -- at present, 47.15% in largecaps, 14.90% in midcap, and the remaining 35.68% in smallcaps. The fund is almost fully invested with only around 4% of its total assets in debt and cash.

How have mutual fund schemes betting on the defence sector performed?

Diversified equity mutual fund schemes with only some portion of their equity portfolio held in defence stock have underperformed vis-a-vis the Nifty India Defence - TRI (which mainly tracks the performance of listed defence companies).

That being said, the positive performance of certain defence stocks (along with non-defence stocks) in their portfolio has helped diversified equity mutual funds, such as Kotak Emerging Equity Fund and Edelweiss Mid Cap Fund, to deliver returns almost in line with their midcap benchmark index.

The Outlook for the Defence Sector in India

India's defence minister, Mr. Rajnath Singh has dubbed the Indian defence industry as the sunrise sector of the future. The Indian government is consistently increasing its defence spending. The 'Make in India' (indigenisation) drive, with emphasis on 'Aatmanirbharta' (self-reliance) in defence, is expected to augur well. Several defence companies in India have a strong and growing order book. Moreover, the book-to-bill ratio (which is the ratio of new orders received to the units billed) of many defence companies is attractively placed.

India is aiming to become a net exporter of defence equipment. The government has set an ambitious target of Rs 35,000 crore of defence exports by 2025. In other words, the defence sector has got enough steam and many tailwinds working in its favour.

That said, many defence stocks are already at their multi-year high (all-time highs in some cases). This is a challenging scenario if you are considering direct investment in defence stocks. It would be worthwhile taking exposure to the defence theme via some of the best-diversified equity mutual funds. Mutual fund schemes holding fundamentally sound defence stocks with encouraging order books (and having the capability to execute orders on time) are likely to benefit and generate wealth for investors in time to come.

Happy Investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.