Geopolitical Risk Mitigation in Defense Equities: Strategic Sector Positioning Amid Russian-Driven Tensions

The global defense and security sector is undergoing a seismic shift, driven by the persistent and evolving geopolitical risks emanating from Russian military actions. As the war in Ukraine enters its fourth year, the ripple effects are reshaping defense budgets, equity valuations, and investment strategies. For investors, the challenge lies in aligning portfolios with the structural changes in military spending while mitigating the volatility inherent in this sector.

The Surge in European Defense Spending: A Structural Shift

According to a report by the Center for Strategic and International Studies (CSIS), European NATO members and Canada have increased defense budgets by 50% since 2022, with Germany's 2025 defense budget projected at $110 billion—making it the fourth-largest military spender globally Defense Budgets in an Uncertain Security Environment - CSIS^[1]. This spending surge is not merely reactive but part of a broader strategic rearmament plan. The European Commission's €150 billion Security Action for Europe (SAFE) fund, coupled with relaxed fiscal rules, underscores a commitment to modernizing capabilities in land-based systems, air platforms, and cyber defenses Defense Budgets in an Uncertain Security Environment - CSIS^[1].

The implications for defense contractors are profound. European aerospace and defense equities, as tracked by the MSCI European Aerospace & Defense Index, have outperformed their U.S. counterparts, trading at a valuation discount while delivering robust earnings growth Defense Sector on the Radar - BlackRock^[3]. This trend is fueled by multi-year procurement contracts and joint ventures, such as Rheinmetall's partnership with U.S. firm Anduril to develop drones, which highlight the sector's shift toward technology-driven warfare Defense Budgets in an Uncertain Security Environment - CSIS^[1].

Strategic Sector Positioning: ETFs, Stocks, and Diversification

For investors seeking exposure to this rearmament cycle, the defense sector offers both opportunities and risks. Defense ETFs like the Select STOXX Europe Aerospace & Defense ETF (EUAD) have surged nearly 80% year-to-date, reflecting the continent's pivot to self-reliance 5 Best ETFs of H1 2025: Defense & Gold Miners Lead^[4]. EUAD's top holdings—Airbus, Rheinmetall, and BAE Systems—are directly benefiting from NATO's revised spending targets, which aim to raise defense budgets to 5% of GDP by 2035 5 Best ETFs of H1 2025: Defense & Gold Miners Lead^[4].

However, concentrated exposure to government-contracted firms carries inherent risks. As noted by BlackRock, U.S. defense spending as a percentage of GDP is expected to rise to 5% by 2035, yet the sector remains underrepresented in many equity portfolios Defense Sector on the Radar - BlackRock^[3]. This suggests an opportunity for active strategies that balance long-term growth with diversification. For instance, the WisdomTree Europe Defense ETF (WDEP) and Global X Defense Tech (ARMG) offer access to advanced technologies like AI and robotics, which are central to modern warfare 5 Best ETFs of H1 2025: Defense & Gold Miners Lead^[4].

Case Studies: Performance and Resilience

The Select STOXX Europe Aerospace & Defense ETF (EUAD) exemplifies the sector's momentum, with a total return of 81.90% over the past 12 months as of September 2025 EUAD Performance History & Total Returns^[6]. This performance is underpinned by Germany's pledge to be fully equipped by 2029 and the EU's €800 billion plan for advanced weaponry and AI Defense Sector on the Radar - BlackRock^[3]. Similarly, Rheinmetall AG, a key EUAD holding, reported a 24% year-on-year revenue increase in H1 2025, driven by a 36% surge in defense business sales Defense Budgets in an Uncertain Security Environment - CSIS^[1]. Its record €63 billion order backlog underscores the structural demand for European defense capabilities Defense Budgets in an Uncertain Security Environment - CSIS^[1].

Navigating Risks and Long-Term Outlook

While the defense sector's growth is compelling, investors must remain cognizant of macroeconomic headwinds. Rising deficits from increased spending could strain public finances, particularly in countries with weaker fiscal positions. Additionally, geopolitical volatility—such as Russia's domestic security gaps and border control issues—introduces uncertainty into long-term procurement timelines How Russia’s War in Ukraine is Creating Domestic Security Gaps^[5].

Nevertheless, the sector's resilience is evident. Private equity investment in aerospace and defense surged to $4.27 billion in early 2025, reflecting confidence in the sector's ability to weather short-term shocks PE defense investment surges in early 2025 as geopolitics drives change^[2]. For investors, the key is to adopt a balanced approach: leveraging ETFs for diversified exposure while selectively investing in high-conviction stocks with strong government contracts.

Conclusion

The defense and security sector is no longer a niche play but a central theme in global investing. As European nations and their allies recalibrate to a prolonged geopolitical standoff with Russia, defense equities offer a unique combination of growth and stability. By strategically positioning portfolios through ETFs, technology-focused stocks, and active diversification, investors can mitigate risks while capitalizing on the structural rearmament underway.