- Malick Dioume, Director, Risk Management, Bank of Haiti
- Reinhold Felber, Head of Reserve Management, Operations Department,
Central Bank of Luxembourg
- Hatem Ibrahim, Chief Financial Officer, Central Bank of Egypt
- Jarno Ilves, Head of Asset Management, Bank of Finland
- Franz Partsch, Director of the Treasury Department, National Bank of Austria
- Raivo Vanags, Head of Market Operations Department, Bank of Latvia
- Michał Zajac, Head of Risk Management, National Bank of Slovakia
- Requested anonymity, Reserve Manager in Asia
Exchange-traded funds (ETFs) have gained popularity. Net assets invested stood, by one estimate, at a record $9.94 trillion in 2021, after receiving $1.22 trillion in inflows last year.
Proponents advocate low costs of investing in portfolios that hold a number of companies and their associated diversification benefits. However, investors need to balance considerations such as the expense ratio – the measure of a fund’s assets needed to cover operating expenses that impact returns – and tracking errors – how closely an ETF tracks its benchmark index. Additionally, there exists some uncertainty around how ETFs may behave during times of acute market stress.
The era of the low interest rate environment has come to an end: central banks face escalating inflation coupled with growth setbacks due to the Covid-19 pandemic and the Russia-Ukraine war. How can central bank reserve managers use ETFs to navigate these challenges, as well as position themselves for the long term?
How is inflation affecting your reserve management strategy?
Michał Zajac, National Bank of Slovakia: As central banks are traditional fixed-income investors, inflation prospects represent an important factor to be included in allocation models. However, as a bank is running an asset-liability investment strategy, the impact of expected rate changes must be evaluated from a more holistic perspective.
Franz Partsch, National Bank of Austria: Although we don’t have an inflation element in our reserve management goals, the level of inflation and inflation dynamics are important elements of our asset allocation decisions. We are currently looking at the effects on interest rate dynamics, growth perspectives and asset valuations. We expect differences in inflation dynamics between major economies will have an impact on tactical positions.
Jarno Ilves, Bank of Finland: Short term, there has been no escape from inflation. Almost all asset classes, except for commodities, have suffered. In planning our investment strategy for next year, inflation and its effect on interest rate markets is a key issue to consider. The uncertainty regarding interest rate outlook puts more weight into duration considerations. It is also important to have enough liquidity to implement changes in market outlook change scenarios.
Raivo Vanags, Bank of Latvia: A common theme this year, whether you’re a fixed-income-only investor or you have a diversified portfolio reaching outside the fixed-income space, has all been negative. Inflation is proving that it is staying put, while interest rates have been transitioning into levels, the likes of which haven’t been seen since 2007–2011. This might be positive going forward, but we are [more than] halfway through 2022, and so far this has been a year you would not want to repeat.
Reinhold Felber, Central Bank of Luxembourg: Inflation as a single factor is not much. We have not changed asset allocation despite looking into a higher share of inflation-linked bonds and gold, but eventually those proposals were abandoned. The biggest change with inflation is the return of interest rates.
After almost a decade during which euro yields were flat or negative, positive yields have been restored. This also the case for other currencies. While this is primarily a huge challenge as yields go up, it provides new opportunities once they have reached a certain level. Investing in bonds has now finally returned to a positive carry that protects against mark-to-market losses. This new environment requires completely different management to the portfolios compared with previous years.
Hatem Ibrahim, Central Bank of Egypt: Foreign reserves portfolios consist of a basket of different foreign currencies in addition to gold. Inflation has a direct impact on foreign exchange rates. With inflation rising dramatically in the US, the US Federal Reserve violently raised interest rates to face negative inflationary effects. This led to the rise of the dollar against all other currencies and fluctuations in gold prices globally, as gold prices are currently unstable due to the high return on the dollar.
Malick Dioume, Bank of Haiti (BRH): Reserve management at BRH is almost exclusively confined to the USD-denominated fixed-income universe, with exposure to Treasuries, agencies, sovereign, supranational and agency issuers, and corporates.
Current strategy could be best described as ‘wait and see’. Unfavourable market conditions especially since the beginning of 2022, coupled with the portfolio’s maturity profile, have caused the bank to suffer important unrealised losses. The higher level of interest rates and spreads, compared with less than a year ago, has also precluded BRH reserve managers from rebalancing (and thus materialising) losses to try and profit from more attractive reinvestment options. No specific hedging mechanism was put in place prior to this episode.
Reserve manager: The tightening of monetary policy by central banks has pushed short-term rates higher, which has led to selloff in equity markets. This has motivated the central bank to reduce some allocations in equities. With our fixed-income strategy, rising inflation has affected duration play. To mitigate such risk, the current strategy is to short the duration vis-à-vis the benchmark duration of our fixed-income mandates, and increased allocation to higher-quality and more liquid cash equivalents, including short-term bills.
What are the pros and cons of investing in ETFs?
Michał Zajac: ETFs represent a unique form of investment that provide investors with comfortable access to a widening range of asset classes. In general, the pros of ETFs include cost, easy access, operational simplicity, transparent trading, pricing and liquidity.
In contrast, despite expanding rapidly, the ETF market represents a set of limited opportunity investments. Customisable products are not easy to find and proxy solutions might be accepted instead.
Franz Partsch: The major advantage of ETFs in our investment strategy is flexibility for tactical positions. Additionally, ETFs in some market segments are a cost-efficient alternative to passive mandates. Important disadvantages are the restriction to applying internal compliance and risk management rules, as well as high costs in some asset classes and markets.
Jarno Ilves: ETFs obviously provide better liquidity than other outsourced investments, such as mutual funds. An investor can get good diversification easily and with low costs. Background work required to start investing, such as agreements and know your customer (KYC), is lighter than in cases of funds or managed accounts. Alternatively, it may be possible for large investors to get even lower fees via the negotiating process using funds.
Raivo Vanags: ETFs are a strong alternative to other instruments because of:
- Convenience. An ETF is just another security and thus doesn’t require a procurement process as one does with segregated mandates. It means we can invest immediately once the decision has been taken. It also allows an investor to change allocation quickly if necessary.
- Cost. ETFs might not always be the cheapest option, but are a strong competitor to other alternatives. Additionally, given the ongoing ETF price wars, it is possible to get a better-priced ETF without a need to negotiate, such as investing via segregated mandates.
- Liquidity. ETFs trade like securities and an ETF is at least as liquid as its underlying securities. For larger ETFs, liquidity might be even better than underlying securities as, when one investor wants to sell, there might be another investor willing to buy the ETF, and it means underlying securities do not have to be traded at all.
- Structure. It is one security and thus acts as a portfolio. It means investors are not exposed to a risk of individual securities on their balance sheets.
ETFs also have their weak spots because of:
- Investors’ tax environment. Taxation might be particularly relevant for central banks. Given there are double-taxation treaties among countries, investors should check what tax rates are applied at a particular step. For large institutional investors, it might be beneficial to use external asset managers instead of ETFs when tax rates are taken into account.
- Standardisation. Unfortunately, ETFs come as they are, and it means there’s no room to implement any additional restrictions to investment guidelines – it’s take it or leave it.
- Credit risk. Depending on the type of ETF investors are exposed to, there will be counterparty and credit risk inherent in ETF structure. In case of potential problems with one of the counterparts, investors cannot take any precautionary measures, they can only liquidate the ETF holding.
- Operational setup. Traditionally, most reserve managers are used to investing in fixed-income securities. From a trading perspective, ETFs are essentially an equity product. This may present some unexpected operational challenges during the initial setup: for example, some major counterparties you might have used to trade bonds with for decades suddenly need to go through the whole onboarding/KYC process again just to enable equities trading.
Reinhold Felber: Investing in ETFs is often a form of outsourcing. The reasons for this can differ; for instance, lack of capability managing an asset class, allocations that are too small for diversification, new markets and considerations such as cost efficiency. The larger ETFs especially are very liquid and can be traded easily. Passive managers benefit from the monthly rebalancing of the ETF and save time and costs. Equity ETF managers are not required to participate in corporate actions.
Hatem Ibrahim: Pros:
- Lower expense ratio. Expense ratio measures how much the investor will pay over the year to own a fund.
- Diversification. The ETF may contain different asset classes or different sectors within the asset classes. ETFs are considered a good tool to diversify a portfolio.
- Tax efficiency. An ETF is more tax efficient than mutual funds because it realises lower capital gains, as the ETF is a passive fund so they make lower trades and turnover.
- Investment mixes may be limited. Where it does not allow investors the freedom to choose a specific sector or a certain percentage of specific shares out range of the ETF investment pool.
- Trading cost. If the investor buys a stock or a bond he will pay a single fee called a trade fee, but in an ETF there may be an additional layer of fees to cover the expense ratio.
Malick Dioume: ETFs have as many advantages as investment vehicles. They can provide exposure to a multitude of assets and/or strategies, enhance liquidity in portfolio management and reduce overall management fees.
As for cons, we do not know how some ETFs would behave in times of acute market stress should their holders all decide to liquidate their positions at the same time.
Reserve manager: The central bank is only invested in passive ETFs that follow the underlying index. This allows for diversification benefits, ease of trading and reduces cost of transaction, without directly buying and selling underlying securities, which may have tax implications and various account openings within the operation.
Alternatively, one major disadvantage the central bank has experienced is lower market liquidity. Historically, the central bank has faced the issue of the ETF brokers being unable to fulfil the specified number of ETF shares per unit for the buy order.
What ETFs are part of your central bank’s investment portfolio?
Michał Zajac: A couple of ETFs that represent the global equity market exposure, including developed as well as developing markets.
Franz Partsch: ETFs in equities and corporate bonds.
Jarno Ilves: Equity ETFs globally, including some ESG/climate ETFs.
Raivo Vanags: ETFs in the context of emerging market debt and emerging market equity exposure. In addition to competitive pricing and convenience, one of the reasons for using ETFs in these markets is the operational complexity of opening separate accounts at custodians for each market if using segregated accounts or investing in-house.
ETFs also provided the possibility of entering these markets quickly after the respective decision. Now we have exposure in these markets, we might consider other options on how to be exposed to those markets in the future.
Reinhold Felber: Only equity ETFs.
Reserve manager: For confidentiality reasons we are unable to provide the names of the ETFs. However, we can share that we are investing in a number of ETFs spanning across different regions, including the US, Europe and Asia-Pacific.
Over the past year, has your central bank’s portfolio position on ETF investments changed?
Michał Zajac: Our ETF/equity exposure is being built gradually over several years in order to reduce the entry risk. Purchases of ETFs continue, and ticket sizes are only marginally affected by the current market situation.
Franz Partsch: We increased our exposure to the ETFs slightly and added ETFs to our securities lending programmes.
Jarno Ilves: We have moved some of our equity investments to ESG/climate ETFs.
Raivo Vanags: We built up our positions using ETFs gradually during 2021.
Reinhold Felber: Not in terms of size but in terms of composition. We have switched from a broad index ETF to socially responsible investing and ESG-compliant indexes.
Hatem Ibrahim: We are in a very similar position.
Reserve manager: The central bank has a specified benchmark for the aggregate ETF portfolios, which is the MSCI All Country World Index. Recently, the central bank has periodically rebalanced ETF holdings vis-à-vis this benchmark. Additionally, the central bank also takes into account the valuation of the ETFs and has adjusted the weights of different ETFs respectively. In general, the central bank has been very cautious with its ETF investments and reduced some of its ETF positions.
With so much uncertainty in the global financial market, what is your opinion on market volatility in the short (three months to a year), medium (one to five years) and long term (more than five years)?
Michał Zajac: The well-known market prophecy claims that it will stay volatile. The question that remains open regards main volatility drivers. When observing the world today, volatility triggers range from geopolitical, environmental and pandemic, up to economic fundamentals.
Jarno Ilves: Market volatility will continue to be high in the short term while the outlook for the economy, inflation and interest rates is not clear and uncertainty is high. In the medium and long term, volatility will come back down, although will perhaps stay a little higher than we have previously been used to.
Raivo Vanags: Given the current environment, as well as the approaching autumn and winter periods, it is hard to see why volatility would abate substantially in the next three to six months. Given the current (and potential future) geopolitical tensions and being mindful of recent biases, I don’t think I can privde a high-probability forecast further than that.
Reinhold Felber: Market volatility will remain high. The return of inflation is a game changer in many respects. An important one is that central banks will no longer flood the global economy with huge amounts of excess liquidity. The liquidity reduction will result in more competition between asset classes, which will keep volatility high. In addition, the market is now in an adjustment process where the valuation of many assets was dependent on low rates and high liquidity, which will change in the coming months and years. Therefore, I expect volatility to stay high until central banks have reached a level at which their monetary policy has become neutral.
Alternatively, this causes disparity between asset classes. I expect volatility to stay at elevated levels at least for the next 12 months, potentially longer. Additionally, the adjustment process towards higher rates is a dangerous path. The huge amount of outstanding debt can hardly withstand higher rates, which will ultimately lead to more financial market stress.
Malick Dioume: Market volatility is normal, and should be expected by all market participants, even if the subject investment is safe. With this in mind, we expect higher volatility than usual in the short to medium term, given the ongoing fight against inflation. Further into the future, we believe the trends observed prior to the pandemic in the US will resume, mostly a low-growth environment caused by demographic concerns and over-indebtedness in the economy. That should translate into a lower-volatility environment.
Reserve manager: For the short term, market volatility may remain high. This is because of spillover effects from the geopolitical risk of the Russia-Ukraine war, including disruption to the supply chain and tight oil supply. Additionally, the recessionary fears that markets are currently facing from the aggressive monetary policy tightening across central banks, especially the Fed, may add to the current market volatility.
However, in the medium to long term, we may see less volatility in the markets because of the expectation the Fed will not continue with rising rates and instead the decision will be to lower rates in response to inflation and recessionary conditions.
Which ETFs do you think can preserve capital and which can add value to reserve portfolios?
Michał Zajac: The ETF is the form only. The substance and underlying risk/return characteristic is dependent on the market factors covered.
Jarno Ilves: It is not really an issue of investment instruments, rather an issue of asset class or investment strategy. During inflation, real returns are hard to find. Diversified commodities and value stocks are worthwhile to assess. If we return to a lower-growth, lower-inflation economy then interest rate risk is obviously valuable.
Raivo Vanags: We don’t look at ETFs as an asset class. We view them as one of the instruments in our toolbox when making an investment. For example, when we decided to invest in equities, it was a strategic asset allocation decision that we want to invest in equities, how much we want to invest in equities and which benchmark we want to be exposed to. Next, we analysed whether we want to buy equities directly, using futures, an external asset manager or an ETF. When it was decided to make an investment using an ETF, it was because it provided the best combination of cost, convenience, operational risks and other factors.
My advice is to choose which asset class will be the best to preserve your capital and add value to your portfolio, and then decide which instrument is optimal to implement the strategy or to make the investment.
Reinhold Felber: Of course, low-risk ETFs, such as short-term bond ETFs, are best situated to preserve capital. It is, however, not a single ETF that preserves capital but rather an investment strategy. Here, ETFs can play an important role in the diversification of portfolios as well as in the management process (overweight/underweight of asset classes).
Hatem Ibrahim: S&P 500 ETFs can be the optimal choice as they preserve capital and value added to reserve portfolios. This sort of speculation tracks the S&P 500 and incorporates stocks from 500 of the biggest companies within the US. While S&P 500 ETFs have their points of interest, there are myriad reasons to consider buying this sort of venture. Three reasons to select an S&P 500 ETF are:
1. They are more likely to survive market crashes. The stock market will always be subject to volatility, and any investment you buy will need to be strong enough to withstand downturns. While most investments will experience short-term losses during a market crash, S&P 500 ETFs are extremely likely to bounce back over time.
2. They are low maintenance because these are hands-off investments. You don’t need to choose any stocks, you never have to buy or sell investments, and you don’t have to research the individual stocks within the fund.
3. They provide instant diversification. A properly diversified portfolio is key to investing success. No stock is infallible and if you put all your money behind a single company, it can be a recipe for disaster.
Malick Dioume: For capital preservation, even ETFs based on short-term paper (government and/or high-grade corporate) could not offer that year-to-date. In more normal market conditions, it is safe to assume that conservative fixed-income strategies replicated in ETFs can protect principal over a defined time horizon.
For the value part, we currently use two ETFs in the BRH portfolio, each with a specific role within the overall portfolio composition. They represent the overall US stock market, the 500 largest companies (the S&P 500 index). These two ETFs are consequently broadly diversified, well understood, completely straightforward ETFs, with low betas, and with over $30 billion (RSP) and $350 billion (SPY) in assets, respectively.
Reserve manager: The central bank sees that the ETFs that constitute US stocks hold up well with preserving capital and may continue to add value.
What are the compliance, accounting and risk management issues associated with ETFs?
Michał Zajac: From an accounting, settlement and compliance perspective, ETFs represent simple and easy-to-handle products. Cash flows are easier to predict and less frequent, whereas tax treatment is covered by the fund sponsor. From a risk management angle, the challenge lies in the proper understanding of risks bundled in the ETF.
Franz Partsch: The main challenges in compliance and risk management are the application of internal rules, such as exclusion criteria (in particular, specific ESG criteria) and internal risk measure methods, as well as internal limits (for example, overall currency exposure, overall regional exposure and other concentration limits).
Jarno Ilves: They are different for each investor, and every investor needs to make their own assessment depending on their own background and circumstances. Common themes exist, however. ETFs have their own market-makers, which are often different from traditional investment banks.
From an agreement perspective, ETFs are easier to set up, and from an accounting perspective they should be simple. From a risk management perspective, an ETF should, for example, be of reasonable size and have a diversified investor base.
Raivo Vanags: Compliance and accounting are a comparative strength for ETFs as it is only one of the security lines an investor should deal with.
Risk management implications depend on an investor’s approach. It can be relatively easy: an ETF can be treated as a portfolio with high-level data. It can also be complicated if one wants to segregate ETF holdings into various buckets. In the latter case it shouldn’t be more complicated than if an investor invests in underlying securities internally or via an external manager (for those ETFs that provide daily holdings reports). Of course, an investor has to rely on an ETF’s risk management that appropriate controls will be applied continuously.
Reinhold Felber: From a compliance perspective, greenwashing and ESG labelling. From an accounting perspective, there are no problems I am aware of, only that they are always mark-to-market. Finally, from a risk management perspective, pricing of components (fair market value), tracking error, full replication versus derivative substitution, and additional risks from securities lending.
Hatem Ibrahim: From a compliance and accounting perspective, based on investment guideline parameters, this includes performance of portfolios by measuring risk aspects, such as duration, value-at-risk and currency risk, as well as monitoring the limits to ensure they comply with the investment guidelines.
Risk management issues are that they enter 2022 in a weaker position than previously expected. As the Russia-Ukraine war and the Omicron Covid-19 variant spread, countries have reimposed restrictions. Rising energy prices and supply disruptions have resulted in higher, more broad-based inflation than anticipated, notably in the US and many other emerging markets, as well as developing economies.
The ongoing retrenchment of China’s real estate sector and slower-than-expected recovery of private consumption is also having a negative impact on economic growth. This also includes a negative impact on gold because of an increase in inflation and the impact of the high interest rate for USD. Gold prices are currently unstable because of the high return on the dollar and its continued rise. It is expected stability will return to gold prices after the stability of inflation rates in the US, and consequently the trend to a decrease in interest rates.
A proper market risk framework also needs to be put in place. This includes a risk oversight and governance structure, a common risk universe used to categorise and scope the assessment, and a common risk taxonomy to describe risks and their impacts.
Malick Dioume: To out knowledge, these two ETFs don’t have any particular compliance, accounting or risk management issues for BRH. Again, as the ETF universe is broad, not all would be compatible with the institution’s investment policy.
Reserve manager: Since ETFs are passively tracking the index, there are periods where rebalancing is not required. As such, we have encountered our trading accounts with ETF brokers to be closed due to inactivity, resulting in a fresh account opening, which took time to complete.
This is a summary of a forum convened by Central Banking. The commentary and responses to this forum are personal and do not necessarily reflect the views and opinions of the panellists’ respective organisations.
This feature forms part of the Central Banking focus report, ETFs in reserve management 2022