Central banks set for passive equity, active bond push

Global investable reserves are to swell $300 billion by 2020, most of which is likely to go into active fixed income and stock index strategies, finds research by State Street Global Advisors.
Central banks set for passive equity, active bond push

Central banks will hike their allocations to active fixed income and passive equity over the next four years as they seek out higher yields, according to new research by State Street Global Advisors seen exclusively by AsianInvestor. This expected shift spells a large and growing opportunity for asset management firms.

The investable portion of global FX reserves is set to rise $300 billion to nearly $2 trillion by 2020, and 75% of that new money is set to go into actively managed bonds and stock index strategies, found the paper* (see figure 1 below).

Reserve managers "are increasingly becoming convinced that equity in passive form has a core role on central bank balance sheets", noted the report.

Figure 1: Rate of growth of global foreign reserves by asset class, 2016-2020

Some 15%, or $1.64 trillion, of central banks' total global reserves of $10.92 trillion – of which Asia accounts for some $6 trillion – are considered surplus and therefore available for investment. The surplus portion will grow 4.3% annualised by 2020 to $1.94 trillion, outpacing the 2.6% yearly increase in total reserves over the same period, said SSGA. Some 80% of central bank reserves sits in cash and fixed income, the latter mostly in passively managed assets.

The research forecast that passive equity will account for one-fifth of the investment tranche of global foreign reserves in 2020, up from 16.4% now, and that active fixed income would comprise one-quarter, up from 22.8% now (see figures 2 and 3 below). This suggests that central banks will put $121 billion into stock index investments and $107 billion into active bond strategies over that period.

Figure 2: Allocation of investment tranche of global foreign reserves in 2016

Figure 3: Allocation of investment tranche of global foreign reserves in 2020

These may not seem like dramatic allocation changes, but one must bear in mind the sheer amount of capital involved and the fact that central banks can take several years to make even relatively small portfolio shifts – especially those related to risk assets.

“By 2020, we expect central bank investment portfolios to have evolved slightly away from passive fixed income in favour of active fixed income and equity investment,” said the report. “However, it is important to note that we do not expect central banks to reduce their nominal passive fixed income positions. It will rather be that reserve portfolio growth will be channelled into other strategies.”

Logic dictates that such shifts will be driven by the bigger reserve pools – notably China and Japan, which have the most foreign reserves globally, with around $3 trillion and $1.23 trillion, respectively (see also table below).

What's more, many central banks in emerging-market economies (again, dominated by Asian reserves) do not yet invest in equities, but are believed to be considering doing so. Bank of Thailand is one such institution, having proposed that it be able to put as much as 4% of its portfolio into equities, as reported.

Only a small number of central banks have incorporated meaningful equity exposure into their portfolios, said the report. In other words, the average investment tranche is even more skewed toward passive fixed income than it may seem from the allocation breakdown.

Sensible moves

Further diversification into active fixed income and passive equity makes sense, suggested SSGA, which manages around 15%, or $360 billion, of its $2.4 trillion of AUM on behalf of official institutions.

It is hardly surprising that most reserves are in fixed income and cash, as that is where central banks' main expertise lies, noted the report, and this reflects their lower risk tolerance than sovereign wealth funds or endowments.

“However,” said the report, “at the same time, the question arises why the investment tranche ... would have such large exposure to passive fixed income as well as cash products. If the investment tranche is designed to produce extra yield vis-à-vis standard bond portfolios, such a high allocation seems ineffective.”

Ultimately, central banks will be investing much like other investors, seeking out riskier assets and and higher yield beyond their core bond portfolios, said SSGA.

Reserve managers are also being more active in fixed income, such as changing the duration of those portfolios and trading bonds more frequently, said Elliot Hentov, London-based head of policy and research for SSGA's offical institutions group (OIG).

At the more sophisticated end, they are going more into corporate and emerging-market debt, and several are looking at moving more towards an unconstrained fixed income approach, he told AsianInvestor. Some of the larger and more sophisticated reserve entities are even looking at alternative assets, added Hentov, the author of the new report.

Moreover, Hon Cheung, the newly appointed chief investment strategist for SSGA's OIG, sees growing use of exchange-traded funds by sovereign investors, even including less sophisticated central banks.

AsianInvestor published in-depth interviews in early 2015 with the heads of reserve management at the central banks of Indonesia and the Philippines, detailing their approach to portfolio investment.

* How do central banks invest? A glance at their investment tranche, by Elliot Hentov, head of policy and research for SSGA's offical institutions group.

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