Evolving investment activities with ETFs

BlackRock‘s Crystal Wan, Andrew Mackenzie and Pablo Arteaga examine the exchange-traded funds market from the perspective of central banks seeking the tools to achieving their financial goals.

Introduction

Over the past two decades, exchange-traded funds (ETFs) have revolutionised how institutions, wealth managers and individual investors manage their financial exposures. ETFs have helped facilitate more efficient index adoption by offering a low-cost method – often single-digit basis points – of gaining exposure to a wide range of indexes with simple, transparent execution.

ETFs have also proven more liquid in highly stressed market conditions than their underlying asset markets might suggest. Institutional equity and fixed income traders requiring liquidity often use ETFs to balance risk and maintain resilience in their positioning.

Following the global financial crisis that began in 2007–08, a number of central banks began consciously balancing their volatility and liquidity constraints against income objectives. Many central banks believe reserve assets that are well diversified across currency and asset classes generate better risk/return outcomes without compromising their liquidity needs.

When looking to diversify across asset classes, central banks have a broad range of implementation choices. They must consider factors such as available resources, risk/return appetite and investment policy constraints. Investment style is another important consideration, as many reserve managers seek an optimal blend of active and indexed investment strategies.

Just as many institutional investors have turned to ETFs to allocate capital, adjust positions, and manage risk during the turbulent environment wrought by the Covid‑19 pandemic, central bank reserve managers are also discovering how ETFs can satisfy many of the investment criteria they are seeking. In their most recent quantitative easing actions, a number of central banks also used ETFs explicitly to facilitate their policy goals.

In this article, BlackRock experts examine the ETF market from the perspective of central banks. Regardless of level of ETF usage, this feature will aid better understanding of modern market dynamics and the readily available instruments and techniques for central banks to achieve their financial goals.

Introduction by Laurence Fink, chairman and chief executive, and Stanley Fischer, senior adviser, official institutions group, BlackRock

Landscape overview

With 30 years of history now in the rear-view mirror, ETFs have emerged as the most transformative financial innovation of this generation. ETFs offer a wide range of highly precise, transparent exposures with low cost and intraday liquidity features that have driven widespread global adoption.

ETFs have also become the go-to vehicle for transferring risk – particularly in times of extreme market volatility. This was evidenced by surges in ETF trading volumes during the global financial crisis and the Covid‑19 pandemic.

The ETF market cap has more than quadrupled in size over the past decade, growing from $1.1 trillion in 2009 to more than $8 trillion today.

Whether used for risk management, strategic allocations, liquidity or as tools for expressing active views, ETF adoption continues to rise, owing to a range of benefits (see figure 1).

ETFs & reserve managers

Central banks use ETFs for many reasons – here are some examples from BlackRock’s central bank ETF guide that highlight the most common cases.

Case study 1 – Core allocation 

Building a long-term strategic holding in reserve portfolio as central banks diversify from government bonds.

The central bank’s challenge

To increase yield in the reserve portfolio by diversifying from government bonds.

Initial consideration

Corporate bonds were a natural next step. This central bank has a conservative minimum credit rating limit given its low appetite for credit and reputational risks associated with default holdings.

Upon review of several instruments, the investment committee recognised that gaining exposure to the asset class using indexed instruments did not expose the central bank to individual security risk, allowing a lower minimum credit rating tolerance for an index exposure. While a security default would still affect the value of the index, it would be partially mitigated by name diversification in the index.

Action

• The reserve manager purchased investment-grade corporate bonds ETFs in several precise exposures across currencies, which included several benefits:
• Higher yield relative to base government market
• Diversified investment of thousands of securities 
• Ease of execution
• Liquidity. 

Similarly, central banks use ETFs to allocate to other new asset classes as they diversify their reserves. Other popular uses of ETFs for core allocation include global and regional equity, emerging market bonds and other strategies.

Case study 2 – Operational ease 

A central bank looked to increase yield of the reserves; however, the AA minimum credit rating limit couldn’t be altered.

Initial consideration

Given its minimum credit rating tolerance, the central bank explored US agency mortgage-backed securities, as they are highly rated, and bring different types of risk (prepayment) than other asset classes. However, this asset is relatively complex to manage from both investment and operational/accounting perspectives. In addition, many of the newer issues have a higher propensity to prepayment risk, which can cause to-be-announced securities to underperform seasoned indexes when rates fall. This has added to the appeal of ETFs tracking a more seasoned index.

Action

The reserve manager chose an iShares ETF, which offered:

• Higher yield relative to base government market
• Diversified investment of more than 9,021 securities in one instrument
• Ease of execution
• Performance.

Case study 3 – Implementation of responsible investing policy 

A central bank had both credit and equity exposures. When it looked to manage sustainability risk in its reserve portfolio, it decided to maintain its asset allocation, but added an environmental, social and governance (ESG) lens to non-government bond portions.

Initial consideration

With more than 125 iShares ETFs alone, ETFs can serve as useful building blocks as reserve managers implement sustainability policies to their investment activities, with the wide range of approaches that cater for different preferences and objectives across typical exposures. While this is generally a positive feature, it also means additional work is needed by reserve managers to navigate these choices. 

There are various aspects that reserve managers should consider when selecting an exposure, such as the type of ESG screen. Using available data and tools, investors could seek to understand what the index is really exposed to, and why the performance of indexes tracking similar exposures can differ over time.

Key questions

• Objectives – what are the outcomes the central bank is looking to achieve?
  • Risk mitigation (financial and reputational)
  • Example and standard-setting
  • Investment thesis
• Criteria – climate, social or broad ESG?
• Screening – necessity of screens, breadth and revenue thresholds
• Tracking error constraints 
• Portfolio constraints – turnover, concentration versus parent and number of constituents
• Reporting needs and regulatory requirements (labels).

Action

The central bank consulted BlackRock for insight into ESG characteristics of the indexes, their iShares ETFs and portfolio implications. After better understanding ESG screens, index construction methodologies, fund composition and risk exposures, it invested in a blend of iShares sustainable ETFs to match its asset allocation.

Under the hood – Central bank FAQs

How do ETFS work?

ETFs trade on open exchanges. ETF investors do not interact directly with fund providers when buying or selling fund shares, as mutual fund investors do. Instead, ETF investors buy and sell shares on-exchange via a broker as they would with individual securities.

A separate ‘primary’ market involves large institutions transacting with ETF issuers to create or redeem ETF shares based on market demand. For investors, this entire process is managed behind the scenes by a highly regulated network of financial institutions – often banks – called authorised participants (APs).

APs dynamically manage the creation and redemption of ETF shares in the primary market. This process adjusts the number of ETF shares outstanding and helps keep an ETF’s price aligned with the value of its underlying securities. Each share of an ETF represents partial ownership in an underlying portfolio of securities, such as stocks and bonds.

While technically funds, ETFs are typically categorised as securities rather than investment funds. As such, all bond, equity and commodity ETFs are given an equity ticker on Bloomberg, indicating they trade on-exchange.

 

Does the ETF investor have credit exposure to the ETF manager/provider?

Most investors are careful when choosing investment vehicles, as they know they can have different ownership implications and levels of investor protection. For example, iShares are open-ended umbrella investment companies. Legally, they are distinct and separate from BlackRock, which serves as an appointed manager for the funds. The assets of iShares companies belong exclusively to the respective funds themselves, and are ring-fenced and entrusted to a third-party custodian for safe keeping. In the unlikely event BlackRock should cease to exist, iShares funds could continue to operate with another investment manager.

 

What makes ETFs easily tradable, even in times of market stress? 

The simple answer is liquidity – or the ability to buy or sell a security without causing a material change in its price. In fact, ETFs have characteristics that can give them multiple layers of liquidity.

The majority of ETF trading occurs in the secondary market – no different than a stock. Investors buy and sell ETFs using common order types, such as market and limit orders, and ETFs are quoted with bids and offers. Ninety per cent of ETF trades take place in the secondary market.

ETFs have an additional layer of liquidity in the primary market. Primary market liquidity refers to the trading volume of a fund’s underlying securities, and being open-ended funds means that APs can leverage the underlying securities to create or redeem ETF units to satisfy demand accordingly. In aggregate, primary market liquidity is often much greater than an ETF’s secondary market liquidity. It essentially makes an ETF at least as liquid as its underlying holdings.

 

How does ETF pricing work?

An ETF has a market price and a net asset value (NAV). The market price is the price at which investors transact in the secondary market throughout the trading day. NAV is the stated value of the fund’s underlying holdings from the close of business on the previous trading day. 

When an ETF’s price is above or below the fund’s NAV, it is said to be trading at a premium or a discount. The premium or discount may be the result of timing differences and transaction costs not reflected in NAV or short-term supply and demand imbalances for shares of the ETF on-exchange. Over the long term, an ETF’s price is generally anchored to its NAV due to market-makers and APs that act on small arbitrage opportunities between the ETF market price and NAV.

 

How do ETF premiums/discounts to NAV resolve?

While ETF premiums/discounts to NAV are not uncommon, there is a reason they don’t persist indefinitely – the creation/redemption mechanism unique to ETF structures allows an arbitrage that effectively brings an ETF’s price back in line with the value of its underlying securities.

When an ETF is trading at a premium (above NAV), APs will buy the underlying securities at their tradable prices and sell the ETF at its higher price, again arbitraging the spread.

When an ETF is trading at a discount (below NAV), APs – broker/dealers authorised to create/redeem ETF shares – will sell the underlying securities at their tradable prices and buy the ETF at its lower price, arbitraging the difference. Factors that can determine the ‘fair value band’ include the cost of hedging, tax, supply and demand, and operational costs.

 

How do you assess the cost of investing in ETFs?

The total cost of ownership (TCO) is the cost for an investor to invest and hold an ETF, which includes costs arising from internal and external factors (see figure 2). 

The headline cost borne by all ETFs is the total expense ratio. This cost covers the annual expenses incurred to run the fund, which can include the annual management fee, and other costs such as administration costs, custody and audit fees and legal, regulatory and registration expenses, but it is only one of the cost factors that contributes to the TCO.

Conclusion

ETF adoption continues to increase among reserve managers, as more central banks look to evolve their investment activities – whether for diversification, sustainability or other reasons. Choosing the right exposures and vehicles
can be complex, but central banks can find plenty of resources to assist their processes. The BlackRock iShares ETF guide for central banks is a useful starting point.

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