Should your 2025 plan include defence mutual funds?

With geopolitical tensions on the rise globally, the defence sector has emerged as an attractive investment theme for investors seeking diversification and growth. This has sparked interest in defence-focused mutual funds that offer exposure to companies involved in defence manufacturing, technologies, and services. As you look ahead to crafting your 2025 investment portfolio, a natural question arises – should defence mutual funds find a place in it?

To answer this question, you need to objectively assess the performance and prospects of the defence sector, understand the key drivers and risks involved, and analyse whether defence funds align well with your investment goals, time horizon and risk appetite.

Understanding the defence sector growth story

India's defence sector has been growing rapidly over the past decade, driven by rising geostrategic threats, increased defence spending, self-reliance goals, and growth in exports. Take a look at some key factors driving this growth:

• Increasing Defence Spending: India's defence budget has increased at a CAGR of 10% over the last decade. For 2024-25, India's defence budget stood at ₹6.22 trillion, 2.9% higher than the previous year's allocation. This provides sustained funding for military modernisation and domestic manufacturing.
  

• Self-Reliance Push: Government initiatives like 'Make in India' and the 2020 defence acquisition policy focus on indigenisation of defence equipment to reduce import dependence.
  

• Boost for Exports: Defence exports have a target of achieving ₹35,000 crore by 2025 and ₹50,000 crore by 2029 as per the draft Defence Production and Export Promotion policy.
  

• Strong Order Pipeline: The armed forces have a solid pipeline of orders for fighter jets, helicopters, submarines, and other platforms over the next decade to augment capabilities.
  

• FDI Reforms: Raising the FDI limit in defence manufacturing to 74% in 2020 has attracted greater global OEM interest in setting up facilities in India.
  

These drivers have positively impacted industry performance and order prospects of major Indian defence players like L&T, BEL, Bharat Forge, and Tata Motors, among others.

A look at how defence stocks and mutual funds have performed

Optimistic industry trends have reflected in the stock market performance of listed defence companies as well. The Nifty India Defence index, which tracks the performance of major defence stocks, has given stellar returns in recent years as shown below.

• 1-year return as of August 2024: 106%
  
• 5-year CAGR (2019-2024): 29%
  

The index has significantly outperformed broader market returns, highlighting the growth potential in Indian defence stocks.

Defence sector mutual funds, which invest predominantly in defence and aerospace stocks, have aimed to capitalise on this growth trend.

Key drivers for defence stocks and mutual funds

• Government policy reforms to boost indigenisation
  
• Increasing defence capital outlays focusing on modernisation
  
• Expanding export markets for Indian defence products
  
• Technological upgrades and innovations across land, naval and air platforms
  
• Strategic partnerships and joint ventures with global defence technology providers
  
• Strong long-term order pipeline with shift towards indigenous procurement
  
• Capacity expansion by defence PSUs and private sector players
  

However, there are some risks to consider as well while evaluating this sector.

Factors impacting performance of defence mutual funds

• Share price volatility of companies dependent on contract wins and execution
  
• Likelihood of delays in large defence procurement programs
  
• Exposure concentration risk if portfolio not adequately diversified
  
• Changes in government regulations and geostrategic environment
  
• High valuations of defence stocks after recent uptrend
  
• Execution or financial woes of portfolio companies
  
• Limited publicly listed companies in this space currently
  

Should you consider defence mutual funds for 2025?

For investors with a moderate to high risk appetite looking for long-term capital gains, defence funds present a compelling opportunity to benefit from India's rising strategic interests. Their growth potential appears promising backed by favourable government policies. However, these funds come with significant volatility that is inherent to the sector due to fluctuating budgetary allocations, order flows, geopolitical uncertainties, etc. They may witness periodic sharp corrections despite the positive long-term trend.

Hence, defence sector funds are best utilised as satellite investments in a diversified portfolio instead of core holdings. Their inclusion should be based on your risk tolerance, investment horizon and liquidity needs. Limiting exposure to 10-15% of the equity allocation is advisable to minimise concentration risk. Opting for funds with some allocation to leading PSU defence stocks can provide better risk management compared to purely mid/small cap focused ones.

Read More: How to Invest in Mutual Funds for Beginners?

If you are a conservative investor, diversified equity funds spanning multiple sectors or index funds may be more appropriate as core portfolio holdings. These provide stable growth with lower volatility.

Defence sector funds are suitable for investors with 5–10-year investment horizon who seek a blended portfolio with exposure to a high-growth sector from a strategic market segment. For others, moderate allocation is recommended from a tactical perspective to benefit from potential rallies.

Conclusion

Defence mutual funds offer investors like you an opportunity to participate in India's rapidly growing strategic sector. The sector's long-term growth prospects appear promising supported by rising budgets, focus on self-reliance and export promotion. However, it remains susceptible to periodic volatility given its sensitivity to geostrategic headwinds, government policies and defence capex trends.

As an investor, you should, therefore, use these funds for tactical satellite investments as the sector-specific risks attached to this type of investment are best handled by those who are comfortable with risk. For prudent investors, diversified equity funds with multi-sector exposure may be well-suited to matching risk tolerance and objectives. Assessing your investment objectives, time frame, and risk appetite is critical before deciding to allocate toward defence mutual funds in your 2025 investment plan.