Fast-Growing ETFs Total Over $1B

In the supermarket of investment products, municipal exchange-traded funds are a relatively new brand label, but have been steadily gaining attention and experiencing noticeable growth of assets and trading volume since their debut in fall 2007 at the start of the credit crisis.

Analysts who cover the fledgling product say they expect to see further growth from the low-cost alternative to traditional mutual funds - especially as new investors seeking bargains continue to use the muni ETFs to gain entry into the tax-exempt marketplace.

Municipal ETFs gain most of their appeal from having low expense ratios - typically between 17 and 28 basis points, or 40 to 50 basis points lower than traditional mutual funds, according to Chicago's Morningstar Inc. - and by offering investors high quality, liquidity, and increased transparency from a diversified basket of bonds that mirror an established benchmark index, analysts say.

The product is being used mainly by financial advisers who are buying the funds through discount brokerages for their retail customers as a means of supplementing their existing municipal portfolios, or attracting new clients, according to analysts and portfolio managers.

Though still in their infancy, the funds have been growing by leaps and bounds since the fall, when Barclays Global Investors introduced the first municipal ETF - the Barclays iShares S&P National Municipal Fund, ticker MUB - in September.

Currently, the industry has grown to at least 14 municipal ETFs that total approximately $1.1 billion, all of which track indices and are publicly traded on the American Stock Exchange.

At San Francisco-based Barclays, the iShares national muni fund has seen its average daily trading volume increase to $11 million, up from $3.4 million during its September debut, according to Matt Tucker, head of fixed-income investment strategy at Barclays.

"The growth is a healthy sign that investors are coming into this asset class," he said.

Besides the national fund, the firm also launched the iShares S&P California Fund and the iShares S&P New York Fund, both in October.

The three funds together this year have jumped to over $552 million in assets after totaling $394 million as of Dec. 31, 2007, according to Tucker.

"It's been a crazy market, but that has not created any major challenges for us. These are index funds and we try to match the [Standard & Poor's indexes] and we have still been able to do that in this market," Tucker said.

Tim Ryan, a portfolio manager at State Street Global Advisors, said the SPDR Lehman Municipal Bond ETF - which trades under the ticker TFI and debuted back in September shortly after Barclays' national fund - has increased in assets to $270 million from $20 million when it was first launched.

"The product has held up well given the recent events, and there has been very little dislocation," Ryan said. "When bonds were going down in price, the ETFs were going down, but not more than the market."

The fund was also among the best performers among all muni funds in the fourth quarter of last year, with a total return of 1.91%, making it he fifth best, according to data from Lipper Inc.

Meanwhile, State Street has seen also seen growth of its SPDR Lehman Short-Term Municipal Bond ETF, which trades under ticker SHM. Assets in that fund are now $92 million, up from $13 million at inception in October, Ryan said.

Its two other state-specific funds in California and New York, which were also launched in October, have seen less healthy growth likely because the market is anxiously awaiting the outcome of the Kentucky v. Davis case, on the income tax treatment preference that states give their own residents, in the U.S. Supreme Court, Ryan noted.

The court is soon expected to decide whether or not it will uphold the status quo in which most states exempt the interest on in-state bonds from state income taxes, and tax the interest they earn on out-of-state bonds.

The SPDR Lehman California Municipal ETF, which trades as CXA, has grown to $17 million from $13 million, while the SPDR Lehman New York Municipal ETF, trading as INY, has remained at $13 million.

At Van Eck Global, there has been noticeable growth in the trading volume of its three Market Vectors AMT-Free national funds - short, intermediate, and long funds that debuted in February, December, and January, respectively, according to portfolio manager Jim Colby.

The Market Vectors AMT-Free Long Municipal Index ETF has seen the most significant growth, increasing to $24 million in total assets, up from $10 million at inception, and a daily average trading volume of 12,600 shares, compared with just 550 shares at inception, Colby noted.

The Market Vectors AMT-Free Intermediate Municipal Index ETF, meanwhile, launched with $10 million in total assets and now has $15.4 million. Its daily average trading volume has increased to 2,800 shares from 2,300 shares at inception.

The least amount of growth in assets was experienced by the Market Vectors AMT-Free Short Municipal Index ETF, which grew to just $4.9 million from $4.8 million at inception. However, its daily average trading volume has jumped to 4,000 shares per day, from just 565 shares in March, according to data from the firm as of April 30.

The short, intermediate, and long ETFs trade under ticker symbols SMB, ITM, and MLN, respectively, and have expense fees of 16, 20, and 24 basis points, according to the firm's Web site, www.vaneck.com.

Colby said the firm initially anticipated more of an increase in assets and volume, but recent market conditions may have somewhat stunted further growth.

"The turmoil that has surrounded municipals over the last nine months may have obscured some of the realities and opportunities that exist with our funds," he explained.

PowerShares Capital Management LLC launched three municipal ETFs, an insured national funds, and insured state-specific funds in New York and California in October 2007

Portfolio managers and analysts said they believe the growth of municipal ETFs is being sustained by the advantages of lower expense fees, transparency, and the efficiency of intraday trading when compared to mutual funds and individual bonds.

"Being able to trade on an exchange at any point in time during the day gives you liquidity that you don't have with individual bonds," Colby said.

"Fixed-income ETFs have given investors an entirely new way to access muni bonds," Tucker noted.

Jeff Ptak, director of ETF research at Morningstar, said he believes that as long as their net asset values remain relatively stable, muni ETFs should have staying power going forward.

He said muni ETFs are boosting overall liquidity, providing investors with lower expense ratios than mutual funds, and helping preserve more of their tax-exempt income.

"The municipal market is notoriously finicky in that supply is not always there and you're not able to buy millions of bonds in one fell swoop," Ptak explained. "This gives investors market exposure lickety-split."

"Even if you are not head over heels in love with the indexes they are tracking, you're getting exposure to the municipal market at a reasonable price, and preserving more tax-exempt income," he added.

Jeff Tjornehoj, a research manager at Lipper, said despite the timing of their launch, municipal ETFs have performed well overall in the last eight months and continue to show promise.

"When everyone is struggling for a handful of basis points, everything you can gain on that expense ratio seems to count for more," he said.

However, he noted that one major disadvantage of the product is the lack of variety of state-specific funds, with ETFs currently only available in New York and California.

If the outcome of Kentucky v. Davis case is favorable to in-state tax preferences, it could result in more state-specific funds. The opposite would be the case if the Supreme Court upholds a lower court ruling overturning the status quo, Tjornehoj noted.

"While it's still early to say whether they are going to be a long-term winner, the early results are encouraging that investors will keep their interest in muni ETFs," he said.

"Like many other markets we will see the municipal market get more efficient and that will lend itself to further product development in municipal ETFs," said Morningstar's Ptak. "I would expect we are going to see price competition with other providers entering the market and they will try to one up each other, and net-net that's good for investors."

 

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