MMA Paper Examines Growth of Muni ETFs

Municipal exchange traded funds have become part of the municipal market product mix, but should be part of an overall investment program and not solely relied upon, Municipal Market Advisors said in a white paper tracing the evolution of ETFs from 2007 through 2012.

The study was commissioned by Van Eck Associates, sponsor of Market Vector ETFs. MMA said VEAC had no input in the findings of its research study.

The study traces the beginning of unit investment trusts, a fixed number of bonds in which investors could purchase shares, in 1961, actively managed mutual funds in 1976 and ETFs in 2007.

While muni bond ETFs are “a young investment vehicle” they offer “unique qualities that all investors should consider,” MMA said.

The reasons for their growth has been “a re-institutionalization of retail demand for municipals over the last half decade, the demise of municipal bond insurance [making] risks associated with individual bond ownership more challenging [and] the evaluation volatility and losses in recent years from the de-leveraging of municipal proprietary accounts and hedge funds in 2008-2009,” firm said. Add to that, “Meredith Whitney’s incorrect default assumptions, that contributed to extraordinary mutual fund redemptions and losses in the 4th quarter of 2010” and “negative credit headlines,” which “have encouraged individuals to seek professional oversight of their muni investments.”

ETFs offer individual investors “access to fund strategies, but with lower costs and inter-day market access for managing a personal investment plan,” MMA said.

But they involve various risks, including the risk of losing money, the research firm added. Muni ETFs are subject to all of the risks associated with muni bonds, including litigation, changes in national or local legislation, politics, economies, business climates and taxes, and possible bankruptcy, as well as credit, interest rate and other risks, it said.

In its paper, MMA said assets under management have grown faster for ETFs than for mutual funds over last five years, despite the muni market challenges that occurred during this period.

Mutual funds grew somewhat tentatively in the beginning so that for the first 23 quarters of existence, AUM increased to just over $5 billion. In contrast, the AUM of ETFs grew to more than $12 billion during their first 23 quarters, with all but $1 billion concentrated across four ETF providers, according to the paper.

While ETF growth as a percentage of individual holdings represent a smaller share of the market, “the pace of growth has been steeper” than for mutual funds, MMA said.

MMA averaged data on ETF holders for the six largest muni ETFs and found that 97% of assets were recorded as held by a financial advisor, 1.3% were owned by banks and 0.7% were in the possession of a hedge fund.

“The growth of the independent fee-based advisor has coincided with the uncertainly in the municipal market,” MMA said. “The divergent trends of the rating agencies’ upgrades and downgrades, the loss of AAA ratings on most bonds because of the demise of bond insurance, and the persistent headlines concerning public pensions have encouraged and justified individuals to pursue an advisor for their municipal bond investment,” MMA said.

The research firm compared costs for ETFs and mutual funds. It examined 18 ETFs with particular longevity on four different investor platforms. Expense ratios ranged from as low as 0.20% to as high as 0.35% and below the fees associated with mutual funds, it said. The average expense ratio for the 18 ETFs was 0.25%, compared to 0.97% for muni bond mutual funds, according to the paper.

“The expense ratio is a key comparative measure for an investor, but funds can also have sales fees that can influence an investor’s decision-making process when reallocating assets, “ MMA said. The top-preforming, though volatile, Oppenheimer high-yield fund has a relatively low management fee of 0.37%, but includes a 4.75% front-loaded fee to enter the fund and an additional 0.15% in 12b-1 fees, which are marketing or distribution fees.

Transparency is another issue. While mutual funds report their holdings on a quarterly basis, ETFs disclose their investments on a daily basis.

“The timeliness of the disclosure of investments is consistent with the basic tenants of the ETF product, which is to provide investors a consistent investment portfolio and intra-day on-demand execution,” MMA said.

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