ETFs (exchange traded funds) are gaining popularity among individual investors who want diversified investments that are traded on an exchange. However, central banks buy ETFs too, but why?
Central banks buy ETFs as a way to stimulate the economy in times of economic downturn. They often choose ETFs over mutual funds and individual bonds because they know what type of securities and how many are in each ETF, and purchasing an ETF impacts multiple bonds simultaneously.
This article will explain what ETFs are, why central banks choose to buy ETFs over other investments like mutual funds and individual securities, and how the Bank of Japan and the United States Fed have changed their economies due to ETFs. There are also resources you can use to learn more about the central bank, ETFs, and how the two go together.
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Table of Contents
What are ETFs?
ETFs are a common investment type among individual investors. ETFs are similar to mutual funds in that they are a group of securities that you can invest in, but they are not actively managed like mutual funds.
According to Bankrate, “An exchange-traded fund (ETF) offers investors a way to pool their money in a fund that invests in stocks, bonds, and other assets and then receive a stake in that pool.”
ETFs can include just one security, or they can be composed of many securities, usually in the same sector or category. While they are similar to mutual funds, ETFs are traded on exchanges like stocks.
Investors can buy and sell ETFs whenever the market is open. Information is readily available on financial websites and tv channels about the current prices, fees, and trends for the ETFs that are trading.
Why Do Central Banks Buy ETFs and Not Other Investments?
Central banks are buying ETFs, but why did they choose ETFs over other types of investments? Why not just buy bonds or invest in mutual funds?
ETFs are better than single-security investments like one bond or stock. ETFs are usually made up of more than one security, so when a central bank invests in an ETF, they invest in lots of different securities, not just one.
Investing in many securities at once saves central banks time compared to investing in securities one by one.
Central banks choose ETFs over mutual funds because they are a passive investment, and the contents of an ETF does not change, unlike mutual funds. With ETFs, investors know what securities are in the fund before they choose to invest. Knowing the contents of an ETF is good for a central bank because they can make sure everything they want to invest in is included.
With mutual funds, a brokerage or account manager chooses what to invest the mutual fund money in, whether it be stocks, bonds, or other securities. While most mutual funds have a set theme, such as technology stocks or long-term bonds, the securities in the mutual fund can change at any time at the discretion of the account manager.
The possibility of a mutual fund adding or losing specific securities is not good for a central bank investing in them. The central bank may choose a fund because of specific securities within it, and they do not want those to come out of it.
On the other hand, the mutual fund manager may add securities that the central bank does not want to or cannot invest in due to a conflict of interest or a variety of other reasons.
Central Bank of Japan
Japan was the first central bank to buy ETFs, starting in 2010, to stimulate the economy. The first year, they limited the ETF purchases to four hundred and fifty billion yen, equal to more than four billion US dollars. Ten years later, the central bank invested a record twelve trillion yen into ETFs, equivalent to more than one hundred billion US Dollars.
So how did the decision to purchase ETFs affect the Japanese economy?
A 2019 study by the National Bureau of Economic Research (link in article sources down below) analyzed how the Bank of Japan’s ETF purchases from January 2011 to March 2018 (which made up 3.5% of Japan’s GDP) affected the economy and the country’s economic growth.
During the study period, the total assets, shares issued, and valuations all increased. However, the researchers concluded that the increase was due to cash and short-term securities, not ETFs.
The money invested in ETFs was not as effective at stimulating the economy as the Bank of Japan expected. The investments did not grow as expected, and therefore neither did the economy.
According to the researchers, exchange transfer fund purchases “are a problematic tool for stimulating economic growth through high broad-based private-sector corporate investment.”
Central Bank in the USA
The Fed, the central bank of the United States, began buying ETFs in the spring of 2020 to help a rapidly declining economy during the COVID-19 pandemic. Over a month-long period in April and May 2020, the Fed bought more than three hundred million dollars worth of ETFs.
Compared to Japan, the Fed’s time buying ETFs has been considered a success. When the global pandemic started, which was why the US central bank bought ETFs, corporate bond yields had doubled over a few weeks.
But, when the Fed started buying ETFs composed of corporate bonds, the corporate bond yield decreased to less than right before the economy collapsed. The lower the corporate bond yield, the less risky the bonds are and the more stable the corporate bond market is. Therefore, the purchases of ETFs were considered a success.
However, you should take this comparison with a grain of salt. The study on Japan’s ETF purchases covered more than seven years. In contrast, the United States’ ETF purchases were considered successful in June, only two months after the Fed started buying them.
The Fed stopped buying ETFs in July of the same year it started, whereas the Bank of Japan is still buying them. The difference in periods could be the difference between a central bank having success buying ETFs and a central bank not reaching its expected growth due to buying ETFs.
Learn More About ETFs and Central Banks
Suppose you are an investor, economist, or just someone interested in the financial markets and government. In that case, you will find the resources in this section beneficial for learning more about central banks and ETFs.
First, Understanding Central Banks is a book from Amazon.com that explains the importance of central banks in the economy, how central banks play a role in economic growth and decline, and the basics of how central banks function.
Next, this video on YouTube from Asianometry explains why the Bank of Japan has purchased so many stock ETFs and how they became the biggest Japanese stockholder.
Finally, Investing in ETFs For Dummies is a great book on Amazon.com for ETF beginners. You will learn the basics of ETFs, how you can start investing in ETFs, and how to choose the best exchange traded funds while avoiding common ETF mistakes. With these clear, easy to read instructions you’ll be a seasoned ETF trader in no time.
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Conclusion
When central banks buy ETFs, they can stimulate their economies in times of economic crisis. However, the result is dependent on the country, as shown by comparing the United States and Japan. However, central banks prefer buying ETFs over mutual funds and individual securities since ETFs do not change their contents. Buying multiple securities within one exchange trade fund stimulates the market faster.
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