Muni ETFs Grow Fast as Yield-Starved Investors Seek Cheap Funds

(Bloomberg) -- Exchange-traded funds for municipal bonds are growing so fast that they’re giving more established products for retail investors, like closed-end mutual funds, a run for their money.  

This year, muni ETFs have seen record inflows, bringing total holdings to $83 billion. That’s not far off the $98 billion of assets that muni closed-end funds had at the end of the third quarter. 

And the growth isn’t over. Citigroup Inc. analysts led by Vikram Rai said in a report this month that muni ETFs could see their holdings jump by another 40% in 2022. The draw for investors is the cheaper management fees, which average around 0.18% for the top funds, about a third of the level for open-end mutual funds, the analysts wrote.  

The funds are benefiting from demand for municipal debt broadly, given that the bonds still offer attractive yields on an after-tax basis, said Jim Colby, portfolio manager at VanEck. His firm launched a new muni ETF this year focused on sustainable investments.  

The “low cost of access to tax-exempt yields through municipal ETFs in a low-interest rate environment is significant,” he said. “It makes us very competitive and favorably positioned versus other products, mutual funds and closed end funds, and the like.”

Muni ETFs also offer more transparency around their holdings, Colby said, which appeals to investors. And the leverage that closed-end funds often use can expose investors to major price swings. 

Even with this fast growth, muni ETFs own a relatively small portion of the tax-free debt market: 2.1% at the end of this year, according to Citigroup’s projections. Households and nonprofits are expected to directly own about 23%, and separately managed accounts, around another 18%, the bank said. 

Passive vs. Active

Within muni ETFs, investors have been flocking to the cheapest, passively-run fund run by the Vanguard Group Inc. The $14.7 billion Vanguard Tax-Exempt Bond ETF, which trades off the ticker VTEB, has seen inflows of about $4.4 billion this year, a yearly record for the fund and more than any muni ETF tracked by Bloomberg. It charges an expense ratio of just 0.06%. 

Rich Powers, head of ETF and index product management at Vanguard, said the fund’s growth has been “pretty exceptional.” He said the typical muni ETF investors include those who want to build their own bond portfolios using ETFs and those that are put into the funds by financial advisers. 

He said there’s a “huge penetration opportunity” for fixed-income ETFs broadly, and muni ETFs will be among the segments that will benefit from further adoption by investors.  

While most of the $19 billion of inflows this year have been focused on passively run funds, actively managed products are also seeing more uptake. The JPMorgan Ultra-Short Municipal Income ETF, which is actively managed and trades off the ticker JMST, recorded over $1 billion of inflows in 2021, a record for the fund that was launched in 2018. 

And more companies are entering the space with actively managed products. 

MacKay Shields, which subadvises two actively run muni ETFs under the IndexIQ brand, has seen those funds’ assets double this year. John Lawlor, a director at MacKay Shields, said the actively run structure lets portfolio managers take advantage of the inefficiencies in the municipal-bond market rather than being “handcuffed” to an index. 

“We can buy and sell freely with where the relative value is,” he said. “That gives us an edge from a liquidity standpoint.” 

There could be more products on the way. Powers said Vanguard has heard interest from advisers and individual investors in new offerings by the company, which it is considering.

“It’s very possible that we’ll have additional municipal bond ETFs in the future,” he said.

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