In recent years, exchange-traded funds have transformed the way institutional investors manage their asset allocation, with reserve managers leading from the front. Today, many central banks across the world use ETFs, which in some cases can constitute up to 25% of the reserve portfolio. A shift in the asset classes underpinning those reserve portfolios means that ETFs are increasingly focused on ESG criteria.

Reserve portfolio managers have sought to achieve return and income objectives by diversifying from traditional government bond holdings into allocations of credit and equity, subject to volatility and liquidity constraints. When allocating to credit and equity, central banks have often done so using passive index instruments initially, with ETFs being the implementation vehicle of choice.

Many of the features of ETFs lend themselves to reserve portfolio usage. These include operational simplicity, ease of trading, liquidity benefits, transparency and low costs. Many central banks have established front- and back-office functions that can easily adapt to trading and settling ETFs through their existing infrastructures.

One important ETF differentiator is that they can be purchased or sold in the market like any security through a broker, who in turn can access the ETF exchange liquidity. Each ETF will have an equity exchange ‘ticker’, which can be used to view the price at any point in the trading day. Such is their widespread adoption that for some months in 2020 ETFs accounted for 37% of all trading activity on the US stock exchange.

ETF investors do not interact directly with the fund provider as they would with a mutual fund, and investments do not typically require a request for approval process. This makes them ideal for rapid and anonymous implementation. The intraday liquidity means they are more flexible than a mutual fund, which makes them suitable for both short-term tactical opportunities and longer-term strategic asset allocation.

ETF investments can be as small as a single share or up to the largest size that the underlying exposure can accommodate. We have observed that central banks with less than $1bn in reserves, which limits the number of mutual funds available for their (small) initial investment, are able to use a multitude of ETFs instead. Others use ETFs to implement a large position of more than $1bn in a single trade or choose to build a position of equivalent size in smaller quantities more gradually.

A further attraction of an ETF for central banks is being able to effectively outsource the management of index replication. For example, an aggregate bond index might have thousands of bonds across hundreds of issuers making it challenging to replicate without the relevant in-house systems and expertise. The same could be said for a broad equity benchmark such as the MSCI ACWI. In both scenarios, a large, low-cost, liquid ETF with a trading bid/offer spread of less than one cent can often be a more efficient solution for the reserve manager’s portfolio team to trade.

As central banks have increasingly used ETFs for their allocations to equity and corporate bond indices, the incorporation of sustainability metrics alongside risk and return objectives has gained importance.

ESG ETFs have grown apace. Around 50% of all ETF flows have gone into sustainable products so far in 2021, compared to less than 10% in 2018. Various factors explain this shift: investors recognising the impact ESG could have on risk and return outcomes, availability of product choice that enables investors to match ESG objectives to clear outcomes and the benefits of transparency both at the portfolio construction level and end holdings.

Many of these new ESG ETFs have enabled efficient ESG incorporation into reserve portfolios. The choice of ESG strategy also caters for differing objectives. ‘ESG screened’ strategies, where companies involved in certain restricted activities are removed and the remaining companies reweighted accordingly, tend to have low tracking error relative to their respective ‘parent’ index. Investors looking to improve ESG scores and lower their carbon exposure, while monitoring tracking error and limiting active exposure to sectors or countries, can use ‘ESG optimised’ or ‘ESG enhanced’ strategies.

For central banks looking to gain exposure only to highly rated ESG companies, socially responsible investing ESG ETFs apply wider exclusionary screens that only select the top-rated companies based on ESG scores. This leads to more concentrated exposure and a higher active risk, which aligns with the higher ESG conviction of such investors.

More recently, central banks have begun exploring benchmarks with a greater emphasis on the environment. An increasing number have added climate considerations to their investment frameworks, particularly in the euro area as member central banks align with the Eurosystem's stance on climate change-related sustainable investments for non-monetary policy portfolios.

A greater focus on climate is being achieved through stricter business activity screens on fossil fuels, traditional low-carbon strategies or meeting the minimum standards set out by the EU Climate Transition or Paris-aligned benchmarks, which focus on year-on-year greenhouse gas reduction. Central banks might also target positive externalities with their investments, using impact indices. In fixed income, the most common instrument is green bonds, where associated ETFs are available.

Andrew Mackenzie is managing director and Andrew Brickman director of BlackRock’s Official Institutions Group

This story was originally published on the Official Monetary and Financial Institutions Forum (OMFIF)