Defence funds: Enter via SIP with 10-year view to manage valuation risk

Jefferies estimates India's defence sector opportunity at US$100-120 billion over the next five-six years

The Nifty India Defence Total Return Index (TRI) has risen 27.4 per cent over the past three months, outperforming the Nifty 50 TRI, which gained 8.2 per cent. Defence-focused mutual funds have mirrored this rally. The category includes one active fund, HDFC Defence Fund, with assets under management (AUM) of ₹5,487.27 crore, and passive schemes from three fund houses — Motilal Oswal, Aditya Birla Sun Life, and Groww. These schemes manage ₹9,133.82 crore collectively.

 

These funds invest in defence equipment and other stocks related to the defence sector. “A look at the Nifty India Defence Index’s constituents reveals that it is a highly concentrated, top-heavy index. There is also a paucity of listed names in this space,” says Kaustubh Belapurkar, director–manager research, Morningstar Investment Research India.

 

Sound prospects

 

Jefferies estimates India’s defence sector opportunity at $100–120 billion over the next five-six years, with growth projected at 13 per cent compounded annually from financial year (FY) 2022-23 to FY2030. In FY24, domestic defence production reached a record ₹1.3 trillion.

 

“With the trend of protectionism in defence spreading globally, the Indian government has launched the Make in India initiative in the defence sector, which is a key driver for its growth,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

 

The recent border tensions with Pakistan could lead to a spike in India’s defence budget. “This would mean higher revenues and profits for the companies in this sector,” says Abhishek Kumar, Securities and Exchange Board of India (Sebi) registered investment advisor and founder, SahajMoney.com. He adds that investing in these funds may also help investors diversify their portfolios beyond traditional sectors.

 

Concentration, valuation risk

 

Heavy inflows have driven many defence stocks up by 60–70 per cent annually over five years, leading to expensive valuations. “The current price-to-earnings (P/E) ratio of the Nifty 50 is 22, while the Nifty India Defence Index is at 52. The price-to-book value for the two indices is 4 and 13 respectively. Thus, the Nifty Defence Index valuations are more than two-three times the Nifty 50,” says Dhawan.

 

HDFC Defence Fund stopped accepting investments in mid-2024 — a development that investors should regard as a cautionary signal.

 

While defence firms are winning large orders, these typically take years to convert into revenue. “This could create a mismatch between the size of the order book and immediate profitability,” says Dhawan.

 

Kumar highlights that these funds could take a hit if defence spending slows or due to elevated valuations.

 

Right time to enter?

 

Given the sharp run-up, most investors should avoid entering now. Only those with a strong fundamental view of the sector and its companies should invest. “These investors will have to be extremely patient and must be ready to ride out a down cycle before the sector moves up again,” says Belapurkar.

 

Dhawan adds that only experienced investors with a high risk appetite, a grasp of market cycles, and comfort with volatility and timing risk should invest. Kumar cautions that conservative or inexperienced investors, those seeking stable returns, or those with short-term goals should stay away.

 

Exposure to these funds should be taken in the satellite portfolio and limited to 5 per cent of the equity portfolio, while the minimum horizon should be 10 years. Investments should be staggered. Tactical investors should wait for valuations to normalise.