ETFs Growing by Helping Dopes Keep Up With the Pros: Muni CreditMichelle Kaske
Investors are directing a record amount of cash into U.S. municipal-bond exchange-traded funds and are poised to add more, helping to keep borrowing costs for local governments close to four-decade lows.
Buyers are turning to the ETFs, which typically track an index and trade like stocks, even as the largest muni exchange-traded fund has earned 0.5 percentage point less on average in each of the past five years than the broader market for state and city debt.
Still, muni ETFs are one of the fastest-growing parts of the $3.7 trillion local-debt market. They have about $12 billion of assets, up 40 percent from the end of 2011 and compared with $600 million in 2007, data from Lipper US Fund Flows and the Federal Reserve show. The shares are easier to trade than actual bonds, which individuals often buy and hold until maturity, said Bart Mosley at Trident Municipal Research.
Demand for ETFs will grow “as long as continued interest in the underlying muni market is strong,” as they offer a liquid and diverse trading option, said Mosley, Trident’s co-president in New York.
The tax advantage of munis has increased since the start of the year as federal income-tax rates rose for top earners, while the fiscal pact passed Jan. 1 kept the bonds’ tax status intact. President Barack Obama has proposed limiting the value of the muni tax break for higher earners. Muni yields fell to the lowest since 1965 last month.
Investors added $3.9 billion to muni mutual funds in the past three weeks, the most since October 2009, Lipper data show. ETFs still have a way to go before they catch up with muni mutual funds, which held $613 billion as of Sept. 30, up about 16 percent from a year earlier, Fed data show.
While investors are buying more muni ETFs, the funds have failed to match the performance of their underlying indexes or the 5.9 percent five-year annualized return for the muni market, according to Bank of America Merrill lynch data.
The $3.6 billion iShares S&P National AMT-Free Municipal Bond Fund, the largest muni ETF, has earned an annualized 5.4 percent in the past five years. That compares with the 5.6 percent annualized gain for its benchmark, data compiled by Bloomberg show.
The ETF, known as MUB, “provides investors with a broad, actionable exposure to this market that would be difficult to replicate with individual securities,” Matt Tucker, head of iShares fixed-income strategy for BlackRock Inc. in San Francisco, said in an e-mail through a spokeswoman.
“Since inception, MUB has closely tracked” its benchmark, “slightly outperforming when adjusted for fees,” he said.
The $1.6 billion SPDR Nuveen Barclays Short Term Municipal Bond ETF, the second-largest for munis, has returned 0.35 percentage point less annualized for the five-year period than its index.
“They’re not actively looking to outperform their benchmark,” Mosley said about ETF returns. “They’re really looking to deliver performance as close as possible to the benchmark.”
Part of the Nuveen ETF’s tracking loss is because of its 0.2 percent expense ratio, Tim Ryan, who helps oversee the ETF at Nuveen Investments Inc. in Chicago, said in an interview. He said the fund also limits holdings to AAA and AA credits, rather than lower-rated munis that have posted outsize gains in the past year as investors sought their higher yields.
“Given what’s happened in the investment environment, I’m pretty pleased with how our ETFs have held up,” Ryan said.
The ETFs also tend to underperform their mutual fund rivals. Open- and closed-end U.S. muni funds combined earned an average 5.3 percent annualized over the past five years, compared with 4.4 percent for muni ETFs, Bloomberg data show.
That extra gain comes at a cost though. Muni ETFs charge an average of 32 cents annually for every $100 invested, compared with 57 cents for muni mutual funds geared toward institutional buyers and 78 cents for individuals, according to Morningstar Inc. data.
With mutual funds, investors “are getting a manager who will probably have a team of credit analysts doing deep research into each of the different bonds they’re buying,” said Timothy Strauts, an ETF analyst at Morningstar in Chicago. “So they have a better feel for what are good credits.”
The muni market’s 80,000 different states and localities make it a diverse asset class compared with both Treasuries and less than 10,000 corporate-bond issuers, Mosley said. That offers muni mutual fund managers possible value through illiquidity or inefficiencies in the market, he said.
“There is more opportunity for active managers to add value in the municipal space maybe than other asset classes,” Mosley said.
For Strauts, the benefit of ETFs is that they ease the challenge of choosing the right fund at the right time.
“You can buy the ETF, which is going to get you a low cost and get you close to the index returns, or you have a choice between 100 different muni-bond managers,” Strauts said. “How do you know which active investor is going to outperform?”
In muni trading last week, benchmark yields fell to 1.68 percent for 10-year maturities, close to a six-week low, Bloomberg Valuation data show.
Following is a pending sale:
ILLINOIS is set to issue $500 million of general-obligation debt as soon as Jan. 30, according to sale documents. Proceeds will help finance school construction and transportation projects. Standard & Poor’s cut Illinois’s credit last week to A-, six steps below the top, after lawmakers failed to repair the nation’s worst-funded pension system. (Added Jan. 28)