LONDON (Reuters) - European asset managers are reconsidering their policies on investing in defence, under pressure from clients and some politicians to loosen restrictions and help fund the continent's race to re-arm.

Under European Union rules, a number of funds badged as sustainable need to ensure their investments 'Do No Significant Harm'. Many have avoided the sector entirely, with even engine maker Rolls Royce and Airbus, which has a big commercial aviation division, judged off limits.

But as the EU now seeks around 800 billion euros ($870 billion) of investment to bolster defence after U.S. President Donald Trump said Europe must take more responsibility for its own security, the sector is too important to ignore.

Britain's largest investor Legal & General ( LGGNF ) is among those planning to increase exposure to defence, saying the sector's appeal has "risen dramatically" amid deeper geopolitical tensions, Reuters reported on Thursday.

Some of Europe's largest fund groups have separately begun to review their policies at board level, people familiar with the companies told Reuters, although the complexity and controversial nature of rewriting sustainability policies to include arms makers make the process tricky, the people said.

Switzerland's UBS Asset Management told Reuters it was reviewing defence sector exclusions across funds while Mercer, a leading consultant to pension funds, said investors were asking asset managers to include defence in portfolios, including those with sustainability aims.

The EU's spending boost has sent European aerospace and defence stocks including Germany's Rheinmetall and Italy's Leonardo to record highs along with the sector index - and left investors without exposure ruing missed opportunities.

"Some (asset managers' clients) are saying, we actually think it's important that... Europe be able to defend itself. And so we'd actually like you to make investments in this sector," said Rich Nuzum, global chief investment strategist at Mercer, which advises investors managing $17.5 trillion of assets.

Exclusions on investing in controversial weapons - such as cluster munitions and biological weapons - are widely held and informed by international treaties. EU and UK rules do not ban investment in most other defence companies, but an investor focus on environmental, social and governance (ESG) helped dissuade big asset managers from doing so, like with tobacco.

"We're coming to a point where the atmosphere is that if you rule out defence, you're the one who has to explain, not the other way around," said Carl Haglund, CEO of Finnish pension and insurance group Veritas and ex-defence minister of Finland.

Reuters contacted 10 of Europe's largest asset managers to ask if they were reviewing their policies. As well as UBS, Allianz Global Investors said it was reviewing its exclusions, but that the timing was coincidental.

France's BNP Paribas reiterated its commitment to defence.

Amundi and Schroders ( SHNWF ) said their policies were unchanged, while DWS, HSBC Asset Management and Insight Investment declined to say if their exclusions were under review.

The global head of listed assets at Mirova, a smaller Natixis-owned manager, said rearmament efforts and Europe's rising security threats compelled the firm to reconsider its "cautious stance" to defence as it seeks to balance ethical considerations with a need for robust defence capabilities.

But Herve Guez noted the complexity of backing arms makers, highlighting problems around the risks that certain weapons end up in "controversial" countries.

POLITICAL PRESSURE

British politicians last week urged investors to support the military sector and France has floated removing ESG-related curbs on defence loans. Norway's central bank chief has said ethical investing standards may need to change.

Clients have begun asking about defence because companies like Rolls-Royce are "completely excluded" from our investments, said Siobhan Archer, global stewardship lead at LGT Wealth Management, part of the private banking group of the Princely Family of Liechtenstein. LGT is looking "really closely" at what to do, Archer added.

Some fund managers are sceptical.

Carmignac's head of sustainable investing, Lloyd Macallister, said it was wrong to blame ESG funds for thwarting investment into defence, with most traditional funds - which hold far more in assets - including its own, able to invest.

Sustainable funds, he said, were for where "the positive benefit is much more visceral than a load of weapons sat in a warehouse".

Other investors are capitalising on an opportunity.

WisdomTree ( WT ) this week launched what it called the first European defence exchange traded fund.

Tom Vile Jensen, deputy director of trade body Insurance & Pensions Denmark, told Reuters he expected the country's retirement and pension groups to drop most remaining bans on defence investment.

There are signs sustainability-minded funds are rowing back.

European asset managers held 1.1% of their portfolios in aerospace and defence at the end of 2024, up from 0.7% two years earlier, Morningstar data showed.

ESG fund holdings rose to 0.5% from 0.4% a year earlier, the data showed. Barclays analysts this week said the ESG underweight in defence had fallen "markedly" since last year.

"We will go along with a more positive stance (on defence), it's inevitable if you consider the geopolitical situation," Legal & General's ( LGGNF ) CIO Sonja Laud said.

($1 = 0.9228 euros)

(Additional reporting by Sinead Cruise and Chandini Monnappa; Editing by Tommy Reggiori Wilkes and Susan Fenton)