The BOJ has been buying ETFs for a decade as part of efforts to reflate growth and pull Japan out of deflation. It kept ramping up purchases to prevent a slump in stock prices from hurting household and business confidence, and discourage them from boosting spending.
Harada said in an interview with Reuters that buying tailor-made ETFs instead of standardised ones would allow the BOJ to remove small-cap and low-float stocks from its purchases to prevent its huge presence from distorting price moves.
It would also slash fees the BOJ pays to asset management firms, as they are cheaper for tailored-made ETFs than standardised ones when the size of transaction is big, she said.
The BOJ might find idea is worth considering when it conducts a review of its policy tools in March, said Harada, a panel member of Japan's banking regulator and a professor at Chuo University.
"It's been clear for some time that the BOJ's ETF buying is unsustainable," she told Reuters on Wednesday. "The BOJ has no awareness it has become a huge investor in Japan's stock market, which is problematic."
The central bank now holds 47 trillion yen ($444 billion) of the asset, and has become the biggest owner of Japanese stocks.
The bank currently pledges to buy ETFs at an annual pace of 6 trillion yen and by up to 12 trillion yen, a commitment that forces it to keep buying even when stock prices are booming.
BOJ policymakers have said the March review would aim to make the ETF-buying programme more nimble, so it can buy smaller amounts or even stop buying when markets are calm.
Harada said the BOJ's dominance is making Japan's stock market less attractive for foreign investors.
In the long run, the BOJ must remove ETFs from its balance sheet, such as by moving them to a separate entity or selling them to a planned new state fund to aid universities, she said.
"It's very dangerous for the BOJ to keep its balance sheet loaded with risky assets," she said. "Buying ETF is a pretty unusual policy with huge demerits, which is why no other central bank has followed suit."
(Reporting by Leika Kihara and Takahiko Wada; Editing by Simon Cameron-Moore)
By Leika Kihara and Takahiko Wada