Defence funds are booming. Good time to invest?

Recent geopolitical sparks with Pakistan lit a fire under defence stocks. Naturally, defence funds rode the wave too.

Since Operation Sindoor on May 7, 2025, the Nifty India Defence Index TRI has taken off with a 22 per cent rally (as of May 23, 2025), while the broader Nifty 500 TRI barely moved the needle with a modest 3 per cent gain. Clearly, the market picked its favourite regiment.

But should you enlist too? Let’s unpack defence funds and see if they truly deserve a place in your portfolio.

What do defence funds hold?

The defence fund space is still young. There’s just one actively managed fund — the HDFC Defence Fund — which has been around for nearly two years. The rest are young. Five passive options (including ETFs and FoFs) tracking the Nifty India Defence Index, none of which has completed even a year.

Against this backdrop, let’s take a closer look at what these funds are loading up on. For passive funds, we’ll look at the largest constituents of the defence index, since that is what they mirror.

A quick observation tells you that the top three holdings are identical in both the HDFC Defence Fund and the index — and they carry nearly the same weights. Together, these three stocks make up a hefty 54 per cent of the portfolio. Zooming out a bit, the top five stocks account for 69 per cent of the HDFC fund and 71 per cent of the index fund. In short, both portfolios are highly concentrated, with just a handful of stocks driving the bulk of the performance.

Also, it is interesting to note that HDFC Defence Fund has almost 62 per cent overlap with the index.

Returns

Even before the late 2024 correction, the Nifty India Defence Index had soared, delivering blockbuster gains from its January 2022 launch to its July 2024 peak. The index clocked an annualised return of 109 per cent in that span. In absolute terms, that’s a staggering 519 per cent — enough to make most other indices look like they’re standing still. For context, the broader Nifty 500 TRI returned a respectable, but comparatively modest, 19 per cent annualised over the same period.

Then came the correction, and defence stocks weren’t spared. From its July 2024 peak to the February 2025 bottom, the Nifty India Defence Index nosedived 37 per cent, far steeper than the Nifty 500 TRI’s 10 per cent dip. But the comeback was just as dramatic. From the February lows to May 23, 2025, the defence index bounced back with a scorching 65 per cent return in just three months, while the Nifty 500 TRI managed a modest 10 per cent.

What’s driving the defence fever

1. Indigenisation drive: Under the Make in India banner, the government has rolled out a series of reforms to boost home-grown defence manufacturing. The goal? Reduce reliance on imports and strengthen domestic capabilities through indigenous design, development and production.
2. Export explosion: India’s defence exports have skyrocketed, hitting an all-time high of Rs 23,622 crore in FY24–25. That’s a staggering leap from just Rs 686 crore in FY13–14, translating to a cool 38 per cent annualised growth.
3. Robust order books: The push for indigenisation and rising exports have translated into swelling order books for defence companies. Take Hindustan Aeronautics Ltd (HAL), for example — a heavyweight in both active and passive defence funds (nearly 20 per cent allocation). Its order book has grown at an annualised 32 per cent over the past three years.
4. Geopolitical tensions – Heightened tensions with neighbouring countries — especially the recent flare-up with Pakistan — have reinforced the view that India may ramp up its military capabilities, fuelling investor interest in defence stocks.

Should you join?

No doubt, the returns have been mouth-watering, and it’s tempting to jump in. But before you suit up, it’s worth paying attention to the caution flags.

1. High concentration risk: As we already discussed, both active and passive defence funds have a high concentration on just a few stocks. Around 70 per cent of your portfolio’s returns will depend on just five stocks.
2. Valuation risk: The sharp run-up in defence stocks has pushed their valuations into expensive territory, as reflected in key valuation metrics like P/E (price-to-earnings) and P/B (price-to-book) ratios. Typically, higher P/E and P/B ratios indicate richer valuations, while lower figures suggest more reasonably priced stocks.

The table below compares these ratios for defence funds with those of a diversified benchmark like the Nifty 500. We’ve also included the Value Research valuation score (out of 10), which gives a quick sense of how expensive a portfolio is. A lower score signals higher valuation.

It’s clear that the defence index and fund show significantly higher valuation ratios and lower scores compared to the Nifty 500, indicating their underlying stocks are overvalued. When stocks are priced this high, much of the anticipated growth is already factored in, which can limit the potential for future gains.

What should you do?

If you’re a regular reader, you probably know we at Value Research don’t usually cheer for sectoral or thematic funds — and for good reason. Their high concentration risk is hard to ignore, and defence funds are a textbook example. 

Moreover, these funds tend to be far more volatile than diversified ones. Take the recent correction: Defence funds nosedived 37 per cent in just a few weeks, while the Nifty 500 TRI slipped only 10 per cent. Even back-tested data show that during the Covid crash, the Nifty 500 TRI dropped 38 per cent from its peak, but the Nifty India Defence TRI plunged even deeper, falling 43 per cent. Sure, they can deliver eye-popping returns when the theme is hot, but can fall off the cliff more rapidly when the rally ends.

That’s why we prefer diversified categories like flexi-cap or multi-cap funds. These funds spread their investments across sectors (including defence), offering a smoother ride with reduced risk. The table below shows how much exposure some of these diversified funds have to the top three defence stocks of Nifty India Defence index — Hindustan Aeronautics, Bharat Electronics, and Solar Industries. The numbers in brackets indicate how many funds (out of the total in that category) hold each of these stocks.

So, diversified funds offer a measured exposure to defence stocks while spreading the rest across sectors and market caps, giving you balance without putting all your ammo in one basket.

And for those still keen on getting on the defence fund bandwagon, consider capping your allocation to 5–10 per cent of your portfolio.

Also read: Should you invest in income plus arbitrage funds?