Municipal bond exchange-traded funds have enjoyed rapid growth since their introduction in September 2007.

They went from zero in assets at that date to $9.7 billion on March 31, according to the Federal Reserve Flow of Funds.

ETFs started in 1989 with a fund that mirrored the S&P 500. In 2002 the first fixed-income ETFs were launched, according to Joseph Becker, senior fixed and equity income product strategist at Invesco PowerShares.

The first fixed-income ETFs were in corporate and Treasury bonds, Becker said. The areas were chosen because trading in them is more liquid than it is with munis, said Matt Tucker, head of fixed-income investment strategy at iShares.

The first companies to offer municipal ETFs were State Street Global Advisors and iShares, Becker said. Invesco Powershares, which had already been developing muni ETFs, followed a few weeks later.

The clients of iShares wanted a muni ETF because it would provide transparency and diversity of holdings, and transparency of trading, Tucker said.

Invesco PowerShares is one of the largest providers of ETFs in the United States, Becker said. To have a complete lineup, Becker said the firm believed it needed to have a suite of muni ETFs as well.

The funds trade on U.S. stock exchanges. Some of them have primary listings on New York Stock Exchange Arca.

Investors purchase ETF shares from broker-dealers. The broker-dealers serve as “authorized participants” that purchase large blocks of shares from the fund managers in large blocks. The broker-dealers manage the share price so that it closely mirrors the funds’ net-asset values. Net asset value is the sum of the bonds’ market prices.

Coupons payments are generally distributed back to the investors on a monthly or quarterly basis.

Since their introduction in September 2007, muni ETFs have steadily expanded their assets under management (see accompanying graph). In just the first three months of this year, ETFs went from holding 0.23% of all outstanding municipal par value to holding 0.26%.

The fixed-income area is the fastest growing part of exchange-traded funds in the last two to three years, said Kevin Quigg, global head of strategy and consulting for SPDR ETFs at State Street Global Advisors.

Several factors have allowed muni ETFs to advance since their introduction.

Like investing in municipal mutual funds, investing in muni ETFs allows investors to easily and cheaply acquire a diverse group of munis, several muni ETF participants said.

In recent years there has been increased concern about municipal credit risk, Tucker said. A far smaller portion of munis coming to market are wrapped with insurance. These factors have contributed to investors seeking out diversity of holdings as a source of safety, he said.

Also like mutual funds, it can be easier and more convenient for investors to put money into muni ETFs compared to putting money into individual bonds. “The flows that we’ve seen in [iShares ETF] MUB have been in direct response to the challenges investors have experienced this year with obtaining individual bonds,” Tucker said.

Rich Messina, head of ETF product management for Bank of America Merrill Lynch, agrees. By using ETFs individual investors get institutional buying power, he said.

Unlike muni mutual funds, institutional investors including hedge funds, pension plans and endowments use muni ETFs, Quigg said.

Muni ETFs have a number of qualities absent from muni mutual funds that attract investment. For example, they are transparent, according to Tucker and Becker. Whereas the investor can see what an ETF has in its portfolio at any moment, in general muni mutual funds only tell investors what they are holding at the end of each quarter, Becker said.

Muni ETFs also offer investors intraday pricing, he said, which is largely absent from the rest of the muni market.

Similarly, ETFs offer excellent liquidity. “An ETF adds liquidity to an asset that traditionally is not liquid,” Quigg said. ETF shares can be bought and sold as long as it is a business day and exchanges are open. By comparison, investors generally can only buy and sell from mutual funds at the end of each business day.

Another obvious advantage to muni exchange-traded funds is that they enjoy lower costs compared to mutual funds. For example, the management fee for the PowerShares Insured National Municipal Bond Portfolio (PZA) ETF is 28 basis points per year, Becker said. By comparison, the average muni mutual fund management fee is 98 basis points per year, Morningstar reports.

The relative low cost of ETFs is partially because in general they are not actively managed, Becker said. In addition, the funds generally have lower administrative costs than mutual funds, he said.

One final advantage that ETFs have compared to muni mutual funds is a relative tax efficiency with regards to capital gains taxes, Becker said. ETFs can allow in-kind redemptions, which cannot be done with mutual funds, he said.

For instance, when an authorized participant redeems shares of a municipal ETF, the fund sponsor can exchange the ETF shares using the in-kind mechanism for an equivalent amount of bonds, Becker said. This in-kind process generally does not create a taxable event for the ETF holders.

Authorized participants are large investing firms that serve as intermediaries between individual investors and ETFs.

By comparison, when a mutual fund gets redemptions it has to sell bonds, which can lead to capital gains or losses, Becker said. The gains are taxable.

Partly because of all these advantages, some observers believe that in the last few years investors have shifted money from muni mutual funds to muni ETFs.

While not simply a benefit to muni ETF investors, the funds can also provide information to the market. “We’re seeing ETFs being used as a proxy to price bonds or a way to determine the prices of bonds that have not traded over several days,” Becker said.

Muni ETFs are not without problems, according to Michael McClary, chief investment officer at ValMark Advisers. There are few state-specific muni ETFs that allow investors to fully capture state tax-exemption, he noted. If municipal interest rates on newly issued bonds go up, then the prices of muni ETF shares will generally go down, he said.

Nevertheless Quigg, Tucker and Becker all expect money to flow into muni ETFs in the near future. “New flavors” of such funds will be rolled out, Tucker said.

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