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From debate to dilemma: should reserve managers diversify when rates are high?

From debate to dilemma: should reserve managers diversify when rates are high?

Panellists discuss tranching, tactical diversification and strategic asset allocation governance in current market conditions during a Central Banking roundtable in collaboration with Invesco. 

“We have just had our strategic asset allocation review,” a reserve manager from a central bank in the Americas told a panel at the Central Banking Autumn Meetings 2023.

US dollars are prominent in the portfolios of the two central bank speakers who took part in the panel. Now, in a new rate environment, should reserve managers focus on short-term returns or take on more risk precisely because yields are higher? “This question is very timely,” the official said.

From debate to dilemma

During discussions at the central bank that had recently reviewed its strategy, there were arguments on both sides as to whether to decrease or increase duration. 

Some personnel at the central bank suggested the duration of even a small portion of reserves should be increased to make the most of higher-for-longer rates. In contrast, others proposed that it would make sense to reduce the duration of the portfolio because they expect elevated volatility to continue. “The debate became a dilemma,” the reserve manager told the room. 

In the end, however, the decision was made not to make any changes. “The decision to stay on hold shows that we are committed to our long-term goals of holding reserves,” the reserve manager said. 

Together with a floating exchange rate regime, the reserve manager expects this to provide insurance against external shocks.

“If we decided to reduce duration, we would be trading tactically something that should be traded strategically,” the reserve manager said.

Any road will get you there

Clear investment policies – such as the long-term goals the central banker outlined – are extremely important, the private investment manager on the panel said. They echoed the sentiments of the central banker, illustrated by the phrase: “If you don’t know where you’re going, any road will get you there.” The panel chair, from a global financial institution, highlighted that the debate on how to develop investment policies has been ongoing for years. 

Every year, the chair said, some reserve managers argue that revisiting goals is a long-term exercise and goals should not be changed frequently. But others maintain that, if you do not revisit goals relatively often, you risk being stuck with numbers and assumptions that are no longer relevant. Here the idea of tactical and strategic asset allocation matters, they said. 

To this point, the private investment manager outlined the benefits of tranching – specifically of having a working capital tranche, a liquidity tranche and an investment tranche. “Investment policies that are tailored to each of those tranches can be very valuable,” they said. 

“You have different risk tolerance levels for those different tranches, and you have different investment horizons within investment tranches,” the investment manager recommended. For the investment tranche they said the argument could be made for breaking it out into strategic and tactical asset allocations that serve different purposes. 

“Tactical asset allocations can be test labs for new investment ideas, as well as the conduit by which there can be an attempt to increase capital returns,” the private investment manager said. Again, that should be dictated by an investment policy separate from the strategic asset allocation, they added.

Tactical diversification

The reserve manager from another Americas central bank highlighted that a key consideration for their institution at the moment is whether it should use tactical allocation to expand into new asset classes. 

“If we want to get some yield enhancement without compromising our central bank’s risk tolerance, which news asset classes should we be looking at?” the reserve manager asked, saying they are looking for finance advice, not an economic response from the asset manager. “Emerging market debt is an attractive space right now,” the asset manager responded. “I do think the dollar is going to start to weaken. And that could be an area of a real opportunity.”

The central banker agreed, adding that now is not the time to focus solely on domestic US markets. They posited that some larger emerging markets are just as liquid as developed markets. 

The panellist the central bank that had decided not to make changes to their strategic asset allocation described how their tactical asset allocation informed their strategic asset allocation. 

The tactical asset allocation is principally used to generate excess returns to the strategic asset allocation portfolio, but it has also been a successful way to gather market intelligence and as a “laboratory for new asset classes”.  

Many of the new asset classes that now make up part of the strategic asset portfolio were initially traded and tested in the tactical portfolio, the central banker said.

This panel discussion was convenued under the Chatham House Rule at the Central Banking Autumn Meetings 2023. Under these conditions, information can shared but not the identities or affiliations of the speakers. The next meetings will be held in Cape Town, March 5–6, 2024. 

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