Fritz Zurbrügg: The Swiss National Bank's investment policy - options
and limitations
Speech by Mr Fritz Zurbrügg, Member of the Governing Board of the Swiss National Bank, at
the Money Market Event, Zurich, 27 March 2014.
* * *
Accompanying charts can be found at the end of the speech or on the Swiss National Bank's website
The speaker would like to thank Dirk Faltin and Adriel Jost for their valuable support in preparing this speech. He
is also indebted to Erich Gmür, Marco Huwiler and Sandro Streit for their insightful comments.
Ladies and Gentlemen
I would like to welcome you to our traditional Money Market Event in Zurich. I am delighted
that so many of you have responded to our invitation. The focus of my comments today will
be the investment policy of the Swiss National Bank (SNB), since it is now exactly ten years
since the new National Bank Act (NBA) came into force, opening up new options for the SNB
in the management of its foreign exchange reserves. Today I want to take the opportunity of
presenting an assessment and acquainting you with the most important aspects of our
investment policy. One of the most important and striking changes since 2004 has been our
investments in equities and I will therefore focus particularly on our equity investments in my
remarks. Following my presentation, my colleague Dewet Moser will take a closer look at
developments on the foreign exchange and money markets.
Monetary policy conditions
Our investment policy differs in a number of ways from that of other large investors, whether
they be private sector investors or sovereign wealth funds. This is due to the SNB's special
role. As an independent central bank, the SNB conducts Switzerland's monetary policy. Our
investment policy is always subordinated to monetary policy and can only be understood in
the context of this policy, which is currently shaped by the minimum exchange rate of
CHF 1.20 against the euro. We introduced the minimum exchange rate in September 2011,
and since then we have enforced it consistently. You will recall how, at the time, the debt
crisis in the euro area was threatening to deteriorate. The upward pressure on the Swiss
franc was immense. For the SNB, it was important to ensure price stability and avert serious
damage to the Swiss economy. Seen from the current perspective, this was certainly
achieved.
Two and a half years after its introduction, the minimum exchange rate remains a key
element in the SNB's monetary policy, and just last week, at our monetary policy
assessment, we decided that it should be maintained. Although the recovery of the global
economy continued in the fourth quarter of 2013, substantial risks remain. In addition, the
conditional inflation forecast for Switzerland has been adjusted downwards in comparison to
December. Internationally declining inflation rates and the slightly stronger Swiss franc are
delaying the rise of inflation into positive territory. The SNB is now expecting inflation of 0%
in the current year and 0.4% in 2015. In 2016, inflation should increase to 1.0%.
Furthermore, the value of the Swiss franc is still high. With the three-month Libor close to
zero, the minimum exchange rate continues to be the right tool to avoid an undesirable
tightening of monetary conditions in the event of renewed upward pressure on the Swiss
franc.
Through the minimum exchange rate, therefore, we are in a position to fulfil our price stability
mandate. However, the consistent enforcement of the minimum exchange rate has
contributed to the substantial increase in our currency reserves. Slide 1 shows that, since
2009, our currency reserves have increased by a factor of about six, and the foreign
exchange reserves are almost ten times higher. Our foreign exchange reserves, that is,
currency reserves excluding gold, currently amount to almost CHF 450 billion, which is over
70% of Switzerland's annual economic output. The expansion of our foreign exchange
reserves means that our balance sheet is more exposed to the volatility of the financial
markets than it used to be. Even slight price changes can have a strong influence on our
investment performance. This has made our investment policy even more challenging.
However, thanks to established processes and a high level of expertise, we are in a position
to meet these demands.
History of investment policy at the SNB
At the SNB, the move towards a sustainable investment policy aimed at optimising risk and
return began as early as the 1970s. At that time, the management of foreign exchange
reserves focused exclusively on the highest possible level of security and liquidity. Imagine a
situation whereby, until 1978, a residual term of only three months was a legal requirement.
As a result, foreign exchange reserves consisted primarily of short-term US dollar
investments, particularly US treasury bills. This led to considerable concentration risk. At the
same time, the potential return was extremely low.
Despite narrow statutory provisions and market-related limitations, the SNB tried to make
use of the existing room for manoeuvre as regards returns. However, it was not until after the
partial revision of the NBA in 1997 that strategic importance was attached to the generation
of returns. This became possible because of the abolition of the maximum residual term of
one year for foreign exchange reserves, which had applied until then.
A further important step towards a sustainable investment policy was the entry into force of
the fully revised NBA in 2004. Although, at the time, the changes to investment policy did not
attract much public attention, they were very important for the SNB's investment activities.
Within the monetary mandate, investment policy was defined as one of the SNB's core tasks
for the first time. Moreover, most statutory restrictions with regard to investment instruments
were removed. And so the foundation was laid for a modern investment policy whose aim is
to optimise the risk/return relationship for assets. However, this was only possible to the
extent allowed by monetary policy, which has always had priority over investment policy
considerations.
In addition to expanding the SNB's freedom of action, investment and risk control processes
were fundamentally adapted and adjusted to the new requirements from 1997 onwards. As a
result, the SNB frequently found itself in the role of central bank pioneer, not only as regards
the choice of investment instruments, but also in the area of investment processes. It is with
some pride that I can report how, in recent years, we have received enquiries from other
central banks about our investment processes. The SNB has also played a pioneering role
with regard to transparency. The composition of our investments is, to a large extent,
accessible to the public. Indeed, the SNB is one of the few central banks which publishes
both its investment allocation and the net result on foreign currency positions on a quarterly
basis.
Investment policy committed to security, liquidity and return
Nowadays, therefore, when investing our currency reserves, we base our decisions on the
criteria of security, liquidity and return. The currency reserves of a country serve primarily as
a means to prevent and overcome crises. In order to fulfil this function, they must, in
essence, be liquid. In the past, the SNB defined liquidity by specifying the term of the bonds.
The shorter the residual term, the more liquid the investment appeared to be. Consequently,
until well into the 1990s, the SNB's foreign exchange reserves consisted almost exclusively
of government paper with very short terms.
With time, the concept of liquidity has changed. For a long time now, we have been defining
liquidity according to the potential for a rapid sale with the minimum possible impact on the
market, rather than as a function of the terms of our bonds. In this case, minimum impact on
the market means that, essentially, we wish to avoid significant price movements. In order to
guarantee this, we hold a substantial portion of the currency reserves in liquid government
bonds, in the most important global currencies. Together with our deposits at other central
banks, these investments presently account for some three-quarters of our foreign exchange
reserves. You can see the current breakdown of our foreign exchange reserves on the
lefthand side of slide 3.
For the criterion of security, the focus is on limiting market and credit risk. In this case, the
decisive role is played by diversification across different currencies and instruments. We
engage in currency diversification by holding our foreign exchange reserves in the currencies
of all large advanced economies; the highest percentages are accounted for by the euro
(48%) and the US dollar (27%), as you can see from the chart on the right-hand side of
slide 3. Looking at the individual currencies, diversification occurs via the different investment
instruments. As I have already mentioned, since the full revision of the NBA in 2004,
additional bond categories such as corporate bonds and the bonds of foreign authorities, as
well as equities, have been available.
The diversification effect of equities versus government bonds can be seen in slide 4. For
this chart we divided up the distribution of all daily returns on the US S&P 500 stock market
index since 1999 into ten equally large groups or deciles. Then we ordered the deciles
according to size of returns. The decile with the worst returns is on the left-hand side and that
with the best returns is on the right. Subsequently, we assigned the associated US
government bond returns to these deciles. As you see, there was a good diversification effect
between equities and government bonds. This result is not hard to understand intuitively.
During the cyclical upswing, when interest rates are increasing, prices of government bonds
come under pressure, while equity prices benefit from the improvement in the economy and
the better profit outlook for companies. Last year, this negative correlation was very clear and
the diversification effect between equities and government bonds was particularly strong.
However, these interrelationships apply for returns in local currency, while for us, what is
critical is - ultimately - the return in Swiss francs. Here the situation looks somewhat
different. This is because equity prices often correlate negatively with the external value of
the Swiss franc. You can see this relationship in slide 5. The chart is based on the same
approach as in the previous slide. It is easy to see that periods of poor stock market
performance correspond to an appreciation of the Swiss franc, and vice versa. When equities
lose value, this generally occurs in an environment of increased uncertainty in the economy
and on the financial markets. In such situations, demand for the Swiss franc is particularly
strong due to its character as a safe haven. The value of our equity positions is then
subjected to a double loss, first the price loss and second the appreciation of the Swiss franc
against the foreign currencies in which the equities are denominated. So the diversification
effect of our equity investments is diminished, to some extent, by this currency effect. We
cannot safeguard ourselves by hedging an appreciation in the Swiss franc because this
would be tantamount to selling foreign exchange reserves against Swiss francs, and an
investment decision could thus have a monetary policy effect. This example shows how
monetary policy considerations limit investment policy's room for manoeuvre.
A certain diversification effect can also exist between equities and gold. In times when
uncertainty is high, the gold price often increases, while equity prices come under pressure.
The opposite can occur when uncertainty decreases significantly. This was particularly
evident last year, when the gold price underwent a significant correction after climbing for
many years. Of course we cannot rely on this kind of diversification effect always holding.
However, when it does, it is very welcome.
Returns important for preservation of real value
That brings me to the third criterion for our investment activity - return. I would like to stress
that the SNB is not concerned with maximising return for its own sake. Rather, return is
inextricably linked to the criterion of security. Our goal is to ensure that the purchasing power
of the currency reserves at least is maintained over time. That, in turn, presupposes that the
long-term return we earn on our investments is equal to or greater than the average rate of
inflation. Bear in mind that we are aiming to preserve real value in Swiss francs, not in local
investment currencies. This means that a certain amount of positive return in local currencies
is needed, if only to balance out the currency losses incurred in periods when the Swiss franc
is appreciating.
To improve the long-term relationship between risk and return, government bonds in our
portfolio are supplemented by the additional investment categories I have already mentioned.
Generally, the potential returns on equities are greater than those on government bonds
issued by the major advanced economies. They can therefore make a contribution to
preserving the real value of the currency reserves. To be more precise, equities increase the
probability of preserving the real value of the currency reserves. This applies, in particular, in
view of the current low (or negative) real returns on government bonds in core markets. So it
is not surprising that equity investments have become more important for central banks in
recent years.1
How high should the equity share be?
I will now talk in more detail about our investments in equity. So far I have explained why the
SNB invests in equity. In the next few moments, I would like to explore two questions: first,
how high should the equity share in our portfolio be, in rough terms? Second, how are
investments carried out on the stock market? Slide 6 shows that, between 2005 and 2010,
our equity share was around 10%. Furthermore, you will see that, since 2011, we have
gradually increased the share so that it now amounts to 16% of foreign exchange reserves.
When determining the equity share, the challenge is to optimise the risk/return relationship in
the portfolio. As the saying goes among investors: if you want to eat well, buy shares, if you
want to sleep well, buy bonds. The idea behind this old stock market saying is that,
compared to most government bonds, equities have a higher potential return but are
generally more risky. Nevertheless, we need to begin by taking account of the diversification
effect of the equity investments. The interrelationships can be seen if we look at the stylised
efficient frontier path shown in slide 7. We start with a portfolio consisting solely of
government bonds (point A in the chart), and then start adding equities to the portfolio. In the
initial stages the risk and returns structure of the portfolio improves. The expected return
increases and the expected risk decreases. However, once a given equity share is
exceeded, at point B, a trade-off between risk and return begins. At this stage, each further
increase in potential return has to be 'bought' at the cost of increased risk. In the extreme
case, we reach the situation of a portfolio consisting solely of equities (point C). The equity
share we are aiming for is obtained by weighing up additional risk against higher potential
return.
After potential return and risk have been weighed up in this way at the SNB, what does the
final result look like? Fundamentally, our efficient frontier presents less attractive risk/return
combinations than in the case of many other investors. That means our efficient frontier
tends to look more like the right-hand curve in slide 7. In addition, the point at which a further
increase in the equity share means a rise in total risk (point B') is reached earlier than in the
left-hand curve. I have already talked about the reasons for this. First, we can naturally only
hold currency reserves in foreign currencies and not in Swiss francs. Second, the Swiss
franc has the character of a safe haven at times of increased uncertainty in the economy and
on the financial markets. Thus I have shown how there is a frequent negative correlation
between equity prices and the external value of the Swiss franc. Third, I have also drawn
attention to the fact that we have to carry the currency risk against the Swiss franc, since for
monetary policy reasons we cannot hedge it. These factors constitute significant limitations
on the diversification effect of our equity investments. Ultimately, they mean that the SNB's
equity share is fundamentally lower than in the case of many other investors. The point at
which we wish to position ourselves on the efficient frontier between B' and C' depends on
how we weigh up additional risk and higher return. At present, this weighing-up produces the
equity share of 16% which I mentioned before.
The SNB as a passive investor
How does the SNB carry out its equity investments? In brief, the SNB is a passive investor in
the stock market. In other words, the SNB basically does not select individual equities.
Instead, we use rule-based procedures to invest in a very broad equity universe. At present,
the SNB holds some 6,000 securities in more than ten currencies. The equity universe on
which our equity investments is based covers some 90% of global market capitalisation. We
mainly invest in mid and large cap companies. This makes sense, particularly in view of the
special liquidity requirements I have already mentioned. In addition, we also place funds in
small cap companies. In terms of market capitalisation these holdings only account for a
small portion of our equity portfolio, but in numbers they make up about three-quarters of all
the securities we hold. This, too, shows the breadth of our equity universe. When selecting
our equities, we use a benchmark. This is a combination of various commonly used indices,
assembled by us. As soon as we have determined the benchmark, equity investment
becomes a largely automatic process.
Why does the SNB not make targeted investments in individual companies or sectors where
an above-average return can be expected? In other words, why do we not engage in stock
picking? Warren Buffett is quoted as having said, wide diversification is only required when
investors do not understand what they are doing. I can assure you that our investment
specialists have an excellent understanding of what they are doing. However, we choose to
have recourse to a broad equity universe for the following four reasons. First, we achieve a
greater diversification effect within the equity segment by investing as widely as possible,
across both regions and sectors. Second, it should not be our objective to enforce strategic
or, indeed, political interests by means of our investments in individual companies. This could
limit our monetary policy room for manoeuvre and would also make our position vulnerable.
Due to the size of our foreign exchange reserves, the SNB could quickly acquire large shares
in companies, and this might be misconstrued as strategic participations in the event of
active management of our equity holdings and corresponding overweightings in some areas.
Our strategy ensures that holdings in individual companies remain low. Third, through a
passive strategy we can minimise our market influence, since our policy does not cause us to
give preference to individual securities or sectors. Fourth, our investment horizon is very
long-term, that is, it spans several business cycles. The academic literature shows that,
taking account of the costs, it is almost impossible to beat a broad stock index in the long
term and systematically.2
However, there are two areas in which we limit our investment universe in a selective
manner. First, we exclude mid and large cap banks from our portfolio in order to avoid
conflicts of interest. Second, we do not include companies that are in gross violation of
ethical principles. I will explain these two points in more detail.
Conflicts of interest with regard to investments in mid and large cap banks can come about
because, according to its mandate, the SNB is also required to contribute to the stability of
the financial system. Under certain circumstances, this can mean that the SNB has an
information edge over the market with respect to the financial situation of individual banks. In
order to avoid any suspicion that the SNB might make use of this information edge in its
position as an investor, we completely exclude all investments in equities of such banks.
Moreover, by doing so, we prevent market participants from attributing any signal effects to
our transactions. On the question of conflicts of interest, I would also like to stress that, as a
matter of principle, the SNB does not own equities in any Swiss companies for investment
purposes.
Should equities of individual companies be excluded from the investment universe on the
basis of ethical criteria? We have been discussing this question for a considerable time and
last year we made a fundamental decision. We do not invest in companies that blatantly
infringe certain ethical principles. This decision was already implemented in the fourth
quarter of 2013. To be specific, we do not hold equities in companies which produce
internationally banned weapons, seriously violate fundamental human rights or
systematically cause severe environmental damage. We believe that it is in the best interests
of monetary policy if the SNB achieves sound investment returns through the widest possible
diversification. Consequently, for us it is not a matter of excluding entire sectors or industries.
On the contrary. We simply wish to exclude those companies for which there is clear
evidence of a serious violation against the principles mentioned. Therefore the number of
companies involved is very limited.
How do we implement this? We are convinced that it would not be practicable for the SNB to
examine the conduct of dubious companies itself. In our view, the SNB's tasks and
competences do not include the filtering-out of such companies. For the implementation, we
therefore use analyses by established institutions with relevant experience. These help us to
constantly review which companies fulfil the predefined exclusion criteria.
You will understand that we do not provide any detailed information on the exclusion
procedures or the equities involved. As I mentioned at the beginning, the SNB always
endeavours to maintain a high degree of transparency and, in this respect, goes further than
other central banks, especially when it comes to its investment policy. Nevertheless, it is also
an established principle that we do not reveal any details about the various external
providers whose services we employ in our operations. The same applies to details about the
indices we use, or, indeed, the individual securities. Such information could trigger
undesirable movements in the market, which would go against our principle of ensuring the
minimum possible impact on the market. In addition, this information could also limit our
investment policy room for manoeuvre and thereby have a negative impact on the
investment results.
Final considerations
The NBA of 2004 gave the SNB new options in investment policy. We used these for a
consistent and comprehensive further development of our investment policy. In particular, we
significantly improved the risk/return profile of our foreign exchange reserves through a
number of diversification measures. As I have shown, our equity investments played an
important role in this process.
However, although the SNB is a large global investor, its main task is monetary policy in the
service of the Swiss economy. Consequently, monetary policy affects both the size of our
investments and the criteria and principles we apply in managing them. My comments have
shown that the options available to our investment policy are limited in several areas by the
primacy of monetary policy. This includes the fact that we cannot hedge currency risks with
respect to the Swiss franc.
These limitations are sometimes reflected in the annual results. Even though we have
continually extended our investment policy, thereby improving our return options, there have
occasionally been years in the past with negative results. This may be repeated in the future.
Given the current level of our foreign exchange reserves, a small loss in percentage terms
can mean a high figure in Swiss francs.
That is why it is all the more important for me to stress, once again, the SNB's main task,
which is monetary policy. The success of the SNB cannot be measured in terms of our
annual results but by whether we fulfil our mandate, which is to ensure price stability while
taking account of the development of the economy. In order to fulfil this task, the minimum
exchange rate remains necessary for the foreseeable future. And so we return to the starting
point of my presentation. I will repeat what I said before, that only the minimum exchange
rate can prevent an undesired tightening of monetary conditions, should the upward pressure
on the Swiss franc increase once again. Should it become necessary, we will therefore
enforce the minimum exchange rate by buying foreign currency in unlimited quantities.
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