As retail investors have flocked to exchange-traded funds from mutual funds, ETFs have become a significant market mover, especially during periods of stress.
ETFs are "a product that the customers want," said Matt Fabian, a partner at Municipal Market Analytics. "It's just a function we are in. We are in an inherently more volatile market, and ETFs are a small part of why we're here."
"That dynamic, when you have ETFs unloading bonds and putting everything out because they needed to move them, made for these extreme swings," said Keith Solomon, head of Municipal Products at RBC Capital Markets, noting ETFs are "an important investment and hedging tool, but one which can lead to market distortions — especially when used by a few disruptive players."
For example, the recent addition of an ETF to Capital Group's tax-aware portfolio series and model portfolios resulted in $1.5 billion of inflows, which skewed the total muni mutual fund inflow figure for the week ending Aug. 21 markedly higher to $2.3 billion, as 78% of inflows were driven by the single high-yield ETF, according to J.P. Morgan.
For years, mutual funds were the market movers, but as mutual funds shed holdings and ETFs grew in popularity, the latter overtook them.
ETF growth over the past several years has exploded. In the past five years, muni ownership of ETFs has risen almost 118.83% to $137.922 million in 2024 from $63.027 million in 2020, and has increased further in Q1 2025 to $142.35 million, according to the latest Federal Reserve data.
Meanwhile, mutual funds have reduced holdings over the same period, falling 10.3% to $799.825 million in 2024 from $891.262 million in 2020. Muni ownership of mutual funds has fallen further in Q1 2025 to $789.298, the data shows.
Muni mutual funds are almost exclusively owned by individual investors and do not possess the "hot money characteristics like ETFs, where the market surprises and ETF trading and flows can take off for the races," said Pat Luby, head of municipal strategy at CreditSights.
"As [ETFs] grow, investors in municipal bonds need to adjust their ideas of volatility," Michael Pietronico, CEO at Miller Tabak Asset Management, told the Bond Buyer in April.
"If you get an asset class like ETFs becoming a larger part of the market, you're going to get more price swings on a daily basis than you've ever seen in a conservatively run market like municipals," he said.
In general, during times of stress, investors turn to liquidity tools, like ETFs, said Brett Sheely, vice president and head of ETF specialists at AllianceBernstein.
ETFs have become a bit of a price discovery tool "because not every bond in the in the ETF or in the index or out there is trading real time throughout the day, but the ETFs are, and so people are saying, 'I'm going to leverage this liquidity tool to manage during this period, and so I'm getting real time pricing in it,'" he said.
However, there are those that argue ETFs are a mixed bag for liquidity.
Some investors will take advantage of the exchange-traded liquidity of the ETFs to reduce their exposure, but participants demonstrated in April that they are generally impatient about getting rid of munis that they've taken out of an ETF, Luby said.
Additionally, as ETFs are influenced by AI, some of these technologies in the market are causing instantaneous moves on a massive scale when you have headlines, said Ajay Thomas, head of public finance at FHN Financial.
Headline risk is more prevalent in the marketplace, he noted.
"It doesn't take but one comment or one market-moving data point to cause ETFs to shift the market pretty considerably," Thomas said.
During periods of stress, ETFs are a vehicle of choice, and "Liberation Day" and the aftereffects were a "harsh reminder" of that, Luby said.
Munis sold off hard over a three-day period during the tariff-induced market volatility in April, where yields rose nearly 100 basis points. During this time, ETFs started selling, amplifying the weakness within the market.
If, during Liberation Week, many were first selling ETFs, then the ETF would go out and sell bonds at whatever price they could, because that price had to be indexed and there wouldn't be a huge amount of tracking error.
When it snapped back and people started buying ETFs, they went the other way and bought anything in the market.
"So when retail was buying, or banks were buying, or investors were buying and then selling ETFs during Liberation Week, some would say that the velocity of those purchases very much moved the market," a sellside market participant said.
For some, there's the question of whether ETFs moved the market in April or if ETFs reacted to market weakness.
For others, the answer is more clear-cut. While ETFs do not move the market per se, they are a vehicle people use to express a view, Sheely said.
"They are getting real-time value, fair value through that ETF, because throughout the day, there are bid-ask spreads on that ETF, and you are getting a very real-time sense of supply and demand," he noted.
Although the worst of the tariff-induced volatility has passed, the market is, in a way, still in April, Fabian said.
Before April, the market was still seemingly in a low volatility environment, where the curve could be flat, inflation could be predictable and issuance could be readily managed by low yields and tight spreads, he said.
Now, the market is in a different paradigm where potential volatility is higher, and so the curve has to be steeper to adjust for that and yields have to be cheaper as market participants need to be better compensated to invest in a predictably liquid market, Fabian said.
That means bigger fees and spreads for underwriters, more yields for investors and an "incremental burden" on issuers and therefore on infrastructure funding, he noted.
"This is the market we are in, and it's not going to change," Fabian said.
As market-moving events — either from Washington or economic data — continue, the reaction will be more violent in nature in terms of its swings, Thomas said.
However, over time, as people become more familiar with these events and the looming uncertainty, this will minimize some of the daily shock in the market, he noted.
"It'll take some time to [normalize], to see to it. But right now you're sort of on the front end of it," Thomas said.
