The concept of indexing has gained traction in the Muni market.
The scarcity of Munis and the change in markup disclosures for brokers selling to retail clients has been good for the market for tax-free ETF’s. The iShares National Muni ETF whose symbol is MUB has grown rapidly during the last 5 years to $9.8 billion. Despite the market euphoria surrounding Muni indexing, it is important to know there are reasons to question the wisdom of this strategy. These securities are not without drawbacks.
1. Interest Rate Risk: We find it interesting that investors are ignoring interest rate risk to invest in ETF’s since “everyone knows rates are going higher” and MUB has an effective duration of about 5.92 and only pays out a yield of 2.45%. This fund will not perform well in a rising rate environment. We believe it makes more sense to invest in an intermediate strategy with a duration of 4.0-4.5. This strategy will capture more than 80% of the yield of the longer strategy, but only has about two thirds of the risk of the longer strategy. This is a better risk/reward strategy for the client.
2. Not Tax-Efficient: MUB is not very tax-efficient for investors in high tax states and is not a customized solution for investors. It is most appropriate for smaller investors who have limited options due to the size of their account. Larger accounts can benefit from customized portfolios managed by fixed income professionals, which are tax-efficient and have better risk/reward characteristics.
3. Diversification Issues: Since the fund is market cap weighted it has heavy investments in states and cities that issue large amounts of debt (the minimum issue size is $100 million.) For example, 40% of the fund is invested in California and New York. This is a high concentration for the fund, and leaves the fund less diversified than it should be. This would have led to fund underperformance during the financial crisis since California’s budget was under severe stress during that time. The fund also has holdings in Illinois, Connecticut, and New Jersey. These states are all struggling with large unfunded pension obligations. Vanguard’s creation of indexed equity funds is well known and has worked well for investors in the equity markets. An equity index that is cap weighted has a heavy concentration in the companies that have done well. A cap weighted muni index has a heavy concentration in states and cities that have big borrowing needs. This is a significant difference. We don’t think it makes as much sense to apply an indexed strategy to the Muni market where taxes and safety of principal are the main drivers for the investor. A customized portfolio designed to meet the unique investment objectives and tax situation for the client is a more suitable strategy.
4. “Liquidity Mismatch”: Muni ETFs have been growing at a rapid annual growth rate of over 35% since 2008. These ETFs are designed to closely track an index. However, there is some concern about the “liquidity mismatch” between the ETF which is very liquid and their underlying securities which don’t trade very often. In normal markets this does not present a problem. During periods of stress in the Muni market it can be more difficult for the ETF to meet redemptions. The chart below shows the discount or premium of MUB since inception. The largest discount to NAV came in the Fall of 2008 and was -3.54%. There have been other times such as in late 2010 and the middle of 2013 when the fund traded at a significant discount. Investors should be aware Muni ETFs may need to trade at discounts to NAV to meet redemptions when the market is weak. It is possible these discounts could wipe out a year’s worth of the income the portfolio generates.
