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Interest in Actively Managed Muni ETFs Grows

JAN 11, 2013 4:24pm ET
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More asset managers in the business of muni bond exchange-traded funds think they can beat the industry benchmark.

Investors are open to the idea. So, more of them have shown an affinity for actively managed muni ETFs. Assets in these funds are increasing at a rapid pace, almost doubling from one year ago. What’s more, applications to the Securities and Exchange Commission to launch them are on the rise, industry pros say.

As fund flows into muni ETFs keep growing and trading them has recovered from pre-fiscal cliff jitters, asset managers want to create newer ETF products for investors, including those of the actively managed variety.

Van Eck Global, which helps to oversee more than $2.1 billion in municipal ETFs, is one of several firms that hopes to get SEC exemptive relief to run actively managed ETFs, said James Colby, a portfolio manager and senior municipal strategist there.

“I would expect that we’ll see more actively managed muni products coming into the market,” he said. “That will be an evolving trend for no other reason than the market is used to actively managed products, period.”

Actively managed ETFs have taken off in the bond space in general, said Timothy Strauts, an analyst who covers fixed-income ETFs, including muni ETFs, at Morningstar Inc. The muni market might be primed for a real upsurge in interest.

“There’s a market for active management in munis; it hasn’t taken off yet,” he said. “There’s no reason why it couldn’t.”

The theory behind the appeal of active management holds that an asset manager can do better than an index — the Barclays Municipal Index is generally the standard for munis — according to Tom Metzold, a co-director of municipal investments at Eaton Vance. Some investors will choose to pay a management fee because they believe it’s worth the outperformance versus the index, he said.

The market for muni bond ETFs has grown significantly since their introduction in September 2007, to just under $13 billion on Dec. 31, according to IndexUniverse, an independent source for analysis of ETF and index funds.

The market has grown because ETFs generally offer investors many advantages over investing in a muni bond mutual fund or in an individual bond. Muni ETFs let investors buy into a diverse group of munis at low cost. They also are transparent, offer intraday pricing, have tax advantages over mutual funds and are rather liquid, compared with many individual bonds.

And just as total assets to all muni ETFs have risen, so, too, have those for actively managed funds. Assets for actively managed muni ETFs by the end of 2012 were up 93.5% from the same period at the end of 2011, to $312.9 million from $162.7 million. And they’re up 171.6% from the same period closing out 2010, IndexUniverse numbers show, from $115.2 million. Many such muni ETFs launched in 2010.

Actively managed muni ETFs have also grown as a percentage of total muni ETF assets. They rose to 2.41% of all such assets by the end of last year. That compared with 1.78% of all assets at the close of 2011, and 1.54% at the end of 2010.

For muni market participants not looking for a long-term investment, actively managed ETFs provide the opportunity for alpha in a relatively liquid product without the costs associated with mutual funds, Metzold said.

“Sometimes people want to make a strategic or tactical trade instead of a long-term investment objective, such as when they think munis are really cheap,” he said. “Because most mutual funds have contingent-deferred sales charges or front-end load sales charges, the ability to go in and out is very difficult.”

There are concerns, though. Issuers will have a tough time drumming up more interest in actively managed ETFs as long as interest rates remain as low as they are these days. Investors would probably rather secure most of the income, if possible, Colby said, getting to the root of the popularity of and acceptance for passively managed muni ETFs.

“There’s probably a place for both in this marketplace,” Colby said. “But it’s awfully hard to argue for active management when long muni rates are below 3%. It doesn’t leave you much room for a typical management company to charge what typically has been charged for the benefit of active management.”

And while investors must weigh the cost aspect, they must also consider what they’re getting for that cost, said Kevin Quigg, global head of ETF strategy and consulting at State Street Global Advisors. With munis, the upside to those costs might be a more difficult proposition.

“In the investment-grade muni space, it tends to be fairly efficient, so gaining significant outperformance relative to a benchmark is traditionally difficult to do,” Quigg said, “though not impossible.”

Ultimately, diversification carries the day, he added. That means investors will likely appreciate the opportunities that actively managed muni ETFs can bring to their portfolios.

“The best portfolios we’ve seen, and those clients that have managed to meet their expectations, have traditionally had a mix of both active and passive investing in various asset classes,” Quigg said, “munis included.”

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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