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Tactical and strategic ETF use in reserves


Panellists discuss liquidity, oversight and risk management frameworks around using exchange-traded funds (ETFs) to diversify portfolios at a Central Banking roundtable discussion, in collaboration with Invesco

While ETFs began in highly liquid markets, such as the S&P 500, they have increasingly gone into niches. ETFs can be used to take a position on the health of the ocean, against the equity market on bitcoin or, in today’s world, on volatility. During a roundtable discussion held as part of Central Banking’s Summer Meetings, in partnership with Invesco, policy-makers discussed how ETFs have been used by some institutions for diversification.

Before the advent of ETFs as a tool, external asset managers were the only way to gain access to new asset classes not traditionally within central banks’ expertise, an official from an institution in the Americas said. With the goal of diversifying from treasuries and bonds, “four or five years ago, we started using ETFs, primarily to gain exposure to equity indexes”. While initially focusing on the S&P 500, increasingly the central bank has been using ETFs for corporate bonds.

The head of the treasury department at a European central bank said that its institution initially used ETFs as a “transitional instrument”. The central bank has a diversified reserve portfolio consisting of fixed income and traditional reserve assets on the one hand, but also invests in equities and corporate bonds on the other. Similarly, access to new products was initially achieved through external managers with segregated accounts.

Describing the evolution of their investment approach, “two years ago we introduced a new approach to our strategic asset allocation and to the way we take tactical positions,” the official said. The central bank decided to increase its exposure to equities and corporate bonds in both strategic asset allocation and tactical positions, in non-traditional asset classes. From then on, it decided to increase its use of ETFs, “because one advantage of ETFs, compared to segregated accounts, is that you can easily move in and out of the asset class, without big transaction costs”.

Currently, between 70% and 80% of the central bank’s total reserve portfolio is in ETFs. Its equity and corporate bond portfolios are mainly in large, liquid markets in dominant currencies, which enabled the central bank to extend its use of the instrument.

Using ETFs did not come without its challenges, however. One was choosing the right ETF to fulfil liquidity requirements.

“When we talk about tactical positions, in our case normally these would be between around €200 million and €300 million equivalent,” the European panellist said. This was not an issue in US dollars and euros, but the central banker found this was more difficult in smaller markets, such as the British pound, or the Japanese yen.

Risk management frameworks

Another challenge was integrating ETFs into the central bank’s risk management framework. The basket of assets in an ETF may differ from existing risk management requirements in terms of countries or industries the central bank prefers to invest in. “So you have to build a solution around integration.”

A private provider on the panel gave some insights into central banks incorporating ETFs into their risk management frameworks. “Every central bank is going to have their own internal criteria,” they said. “There’s very often this challenge of ensuring that a particular product aligns to the specific needs of a particular bank and can sit within their systems and be risk-managed appropriately.” But the provider said that, in their experience, once this hurdle was overcome, ETF use increases over time.

Over all, with the markets evolving over years in terms of size and liquidity, “we feel more and more comfortable with this instrument and are constantly thinking about using it in a broader sense,” the official from the European central bank said.

There is also an educational component to understanding ETFs, that the provider says plays a role in adoption. Most investors start with the S&P 500 for their core exposures. ETF construction is the process of putting together a portfolio of bonds and equities, and trading that product on secondary markets. Learning more about this results in investors becoming increasingly specific in the exposures they want to take on.

The provider also noted that the vast majority – around 90% of ETFs – are passive, which might resonate with central banks when purchasing third‑party vehicles.

Liquidity and oversight

“That idea of being able to take the whole portfolio and trade that on exchange, with a counterparty, opens up the universe of potential investors,” the provider continued. Some of the liquidity stems from buyers who want some of the underlying bonds in the portfolio, and some from those who want to trade that pool in its entirety. During multiple stress scenarios in the market, ETFs are viewed as having provided incremental liquidity, they said.

In Europe, the Middle East and Africa (Emea), where this provider specialises, available Undertakings for the Collective Investment in Transferable Securities funds – known as Ucits – are designed with a degree of control and oversight necessary for retail clients. ETF holdings are disclosed daily and investors can see all the positions that a particular fund is exposed to.

They noted that an organisation that sits in a very key central governmental role and works for the benefit of the citizens is investing in the same products that each one of those citizens could potentially invest in.

The provider also highlighted some limits. By virtue of the fact that ETFs are generally designed for retail investors, the use of more sophisticated strategies, such as derivatives, is restricted. A benefit, however, is that the central bank’s portfolio management in ETFs can be run by a relatively small team, after foregoing in-house asset management capacity.

Gold and commodities

“Gold has its role as an inflation hedge. It has its role as a safe haven asset in times of market volatility,” the provider said.

The central bank panellists said they have had some discussion around using gold ETFs, but gold has unique features as a commodity for central banks.

The official from the institution in Europe said they hold a lot of gold already and treat it as a strategic reserve. “We don’t actively manage our gold holdings,” they said.

“Every now and then, the discussion of having gold in the asset allocation comes up, either in terms of crisis or, in our case, when interest rates were extremely low,” they continued. In the end, it was not pursued as part of tactical considerations because it would involve moving large amounts of physical gold.

The panellist from the Americas agreed: “Gold for us is more of a strategic asset,” they reiterated. Again, they highlighted that the central bank did have some discussions about using gold ETFs as one of the vehicles to gain exposure, but, for them gold remains physical in their vaults. Gold is also not viewed as a tactical asset class by the central bank.

In Emea, the private provider clarified that technically, the product they offer is not a fund. “It would be structured as a debt instrument – an asset-backed security,” they said. This differs from the US, where funds can hold gold.

Expanding further, the provider explained how the gold exchange traded product works in Emea. A certain number of gold certificates are issued. When those certificates are returned, the gold goes out from a physical vault. “It’s very much straight-through processing,” they said.

The provider acknowledged the unique place gold has for central banks, which was also expressed by the other panellists. Speaking one day to a private bank client and speaking the next day to a central bank client, the starting point would be a broad, regional equities benchmark in their home country, as opposed to having a strategic allocation into gold as a central asset.

The panellist from the central bank in Europe said that it has held discussions about using ETFs for commodities aside from gold in asset allocation. When looking at commodities, they also have to look at their FX exposure because they have currencies in their investment universe that are exposed to commodity price development. “Whether a direct investment into commodities will increase our diversification is always an open issue,” they said.

This central banker explained that, again, they would have to move big amounts to have an impact on asset allocation. In their case they would have to take tactical positions between €500 million and €1 billion. Therefore, instead, they would rely more on the large, very liquid markets to play these tactical positions. “You could get at least some indirect exposure by going into commodity-related currencies rather than commodity instruments directly,” they added.

The discussion chair highlighted that foreign currency reserves are intended to exist on a countercyclical basis, to protect the country in terms of crisis. The Russia‑Ukraine war and the disruptions in the energy market have shown the vulnerability of countries that are dependent on imported energy. It could be argued that the composition of the foreign currency reserves can offset to a certain extent, the exposure of the country, they said.

The private provider made a distinction between physical commodities and the commodities that investors can get exposure to indirectly via futures. As well as gold, silver, platinum and palladium have at different points in the cycle been of interest. But probably more relevant for central banks, they said, is broad commodity exposure – the Bloomberg Commodity Index – which includes oil and agriculture, in its spectrum.

The provider also highlighted that a nuance in Europe, “relative to the UK – and certainly relative to the US,” is the focus on broad commodity ex-agriculture. “There are a lot of countries – a lot of investment groups – where the sensitivity of doing any sort of investing in anything that would be related to the food supply is just viewed as potentially too controversial,” they said.

The panellist chair pointed out that generally, for most central banks, commodities are not within their authorised investment guidelines, though there are some exceptions to that – particularly in Asia. To do a commodities play, only gold may be available. The panel highlighted that another option might be for a central bank to change its investment guidelines and do something more directly related to a country’s own vulnerabilities.

Emerging markets

On investing in emerging markets, the official from a central bank in Europe described exposure as a “balance you have to strike”. “We do not have not a big exposure to emerging markets, currently,” they said.

They reiterated that with a large portfolio, they need very liquid markets to move the amounts they need to have an impact on their asset allocation, so “naturally, you are driven into the bigger markets”. Otherwise, the investment decision would require a lot of small trades.

When they looked into the issue of emerging market ETFs, an issue they came up against is a positive country list that they want to invest in because of credit ratings and to mitigate reputational risks. “For example, we don’t want to be invested into tax haven jurisdictions,” they said. With ETFs, you cannot avoid having at least an indirect exposure into these markets. “Therefore, we refrained from using emerging market ETFs.”

The second issue was that, in terms of cost-efficiency, at least as far as they observe it, emerging market ETFs are more expensive, relative to passive, segregated accounts and compared with liquid markets.

The central banker from the Americas said it does not have any exposure to emerging market ETFs, because as an emerging market, they would not be countercyclical.

Generally, when considering their ETF holdings, reserve levels are a key point of consideration. With ETFs, given that it is an emerging market central bank, it will only be exposed to these asset classes if it thinks it has sufficient reserves to cover its needs in a time of crisis. Currently, the option open to them tends to be exposure to some of the big ETFs for reasons of liquidity. 


This feature forms part of the Central Banking focus report, ETFs in reserve management 2022

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