To Catch A Muni Index

Since the first exchange-traded bond fund appeared in 2002, financial rocket scientists have struggled to launch a tax-free ETF. The development efforts finally bore fruit in September, when Barclays Global Investors launched its iShares S&P National Municipal Bond Fund. Since then, nine other tax-free ETFs have begun trading. Do the new funds deserve attention? Yes. “Because of their low expense ratios, ETFs provide a very efficient way to invest in municipal bonds,” says Benjamin Tobias, a financial advisor in Plantation, Fla.

The new municipal ETFs have expense ratios that range as low as 0.20 percent. In contrast, the average municipal mutual fund tracked by Morningstar charges an expense ratio of 1.04 percent. Expense ratios are directly subtracted from yields. That explains why the average municipal mutual fund yields 3.76 percent, while most municipal ETFs boast yields above 4.3 percent. The ETF yield is the equivalent of a taxable bond yielding more than 6.6 percent for a high-income investor. Such a yield looks very attractive at a time when 10-year Treasuries yield about 3.9 percent.

The Obstacles

In order to develop the rich-yielding ETFs, fund companies faced a variety of challenges. ETFs are index funds, and tracking the municipal market is a difficult task. There are currently more than 2 million individual tax-free offerings. Municipal issuers range from giants, such as the state of California, to tiny municipalities and sewer authorities.

Besides tracking their benchmarks, ETFs must trade constantly and disclose the net asset values of their holdings. This is difficult in a market where bonds rarely trade, and their exact prices can be hard to calculate. In a typical offering, a hospital may issue $10 million worth of bonds. All the securities could be bought by local investors who plan to hold them until maturity. Months or years may pass when none of the hospital issues trade. Investors who do want to sell their bonds could be forced to accept a low price in order to liquidate their holdings.

The three fund companies that currently offer municipal ETFs each sought to overcome the challenges of the tax-free market in different ways. For its SPDR Lehman Municipal Bond ETF, State Street Global Advisors decided to track the Lehman Brothers Municipal Managed Money index, a benchmark that includes 22,000 bonds. Unable to own so many securities, the ETF only holds about 30 bonds that are a cross section of the index.

Buying a small number of bonds, the ETFs aim to disclose holdings and derive the value of the portfolio frequently during the day. “When you buy an ETF, you know exactly what bonds are in the portfolio,” says Ed McRedmond, vice president of portfolio strategies for PowerShares, which has introduced municipal ETFs. “With a bond mutual fund, you only find out the holdings a few times a year.”

Barclays National iShares ETF follows an S&P benchmark that includes 3,000 relatively large bonds from around the country. The fund holds about 49 bonds. Besides the national fund, Barclays also offers ETFs for California and New York — big states with high tax rates. The S&P benchmarks include about 500 bonds for each state. The state ETFs each have about 18 bonds. PowerShares National Insured Municipal Bond Portfolio tracks a Merrill Lynch benchmark that includes 868 bonds. The ETF holds 29 bonds.

Investors should beware that the system of holding only a few bonds is not a perfect solution to the problem of indexing municipals. Even big municipal issues do not trade as frequently as stocks such as ExxonMobil. So ETFs must rely on pricing firms to provide estimates of values during trading hours. Such estimates cannot always be exact. In addition, the small ETF portfolios are likely to suffer from what is known as tracking error, imperfectly mimicking the benchmarks. Fund executives concede that ETF annual returns can diverge from their benchmarks by more than half a percentage point in exceptional years. But State Street argues that its small portfolios can generally track their benchmarks closely. “We work to make sure that each portfolio mimics the duration and yield of the benchmark,” says Jim Ross, senior managing director of State Street. “As long as the characteristics of the portfolio and the benchmark are similar, then the returns should be similar.”

Though it is too soon to compare the track records of the various funds, some distinctions are clear. While the SPDR and iShares funds have average credit qualities of AA, PowerShares only holds bonds that are considered AAA because they are backed by insurance companies. Because of the insurance, PowerShares should present less risk of defaults than the other two funds. But PowerShares may come with more interest-rate risk, since it holds longer-duration bonds. When rates rise, prices of long-term bonds tend to drop steeply. The duration of the national PowerShares fund is 10.17 years, compared to 7.16 years for iShares and 8.02 for SPDR. The longer bonds enable the PowerShares benchmark to yield 4.8 percent, while the other two funds yield around 4.3 percent.

“Double” Tax Efficient

Besides delivering fat yields, the municipal ETFs could prove to be tax efficient. This may seem like an unimportant advantage for funds that are advertised as tax free. But the efficiency of ETFs could be significant — for taxes and other reasons. Proponents of ETFs often say that their favorite investments are more tax efficient than conventional mutual funds. This occurs because of the structure of the funds. In a conventional mutual fund, the portfolio manager constantly buys and sells shares. Under the law, mutual funds must distribute all capital gains annually to shareholders, who must pay the tax tab. But with an ETF, shareholders rarely pay capital gains taxes. To appreciate how this works, consider an ETF that tracks a municipal benchmark. Say an institution wants to put $1 million into the fund. The institution contacts its broker, who assembles a portfolio that includes the 30 or so bonds in the fund. Then the broker swaps the bonds in return for shares in the ETF. When the institution wants to sell, the broker exchanges the ETF shares in return for the 30 bonds. Because the ETF does not buy or sell bonds, the fund does not record capital gains that must be passed on to all the shareholders.

Besides being spared the capital gains taxes that mutual funds may face, municipal ETFs may also achieve other cost savings. In the complicated municipal markets, investors in individual bonds may be forced to sell their holdings at big discounts — or buy bonds at outsized premiums. These high trading costs can hurt the returns of mutual-fund shareholders. But retail ETF shareholders may be sheltered from these costs, which are often shouldered by institutional traders who buy and sell shares. “Because of the trading costs, long-term investors could do better in an ETF than a conventional mutual fund,” says Gary Gastineau, founder of ETF Consultants, which advises ETF issuers in Summit, New Jersey.