Life has gotten easier for municipal bond exchange-traded funds.

A year ago, forced selling and illiquidity foiled many municipal ETFs in their efforts to replicate a target index. Some days, the price movements of some of the biggest ETFs bore little resemblance to the indexes they were meant to track.

Now, with municipal bonds riding a months-long rally and markets enjoying more liquidity and tranquility, the tracking errors that plagued muni ETFs well into 2009 have subsided.

The municipal ETF industry was born about two years ago with the launch of Barclays’ iShares Standard & Poor’s National AMT-Free Municipal Bond fund and State Street Global Advisors’ SPDR Lehman Municipal Bond fund (the latter now known as the SPDR Barclays Capital Municipal Bond fund).

These were soon followed by a slew of others. The sector now includes 18 funds with $5.34 billion in combined market value as of yesterday.

ETFs are stocks that represent ownership in a trust. The trust is populated with assets designed to mirror the performance of a benchmark — in the case of municipals, a bond index.

The idea is that investors can buy the ETF and expect returns equal to an index.

The challenge of managing an ETF is figuring out how to build a portfolio of perhaps a few hundred municipal bonds that matches an index tracking many thousands of them.

For example, the iShares Standard & Poor’s National fund, which is the biggest in the sector, owns 409 bonds worth $1.26 billion.

The index the fund attempts to mimic, the Standard & Poor’s National AMT-Free Municipal Bond Index, tracks 8,114 bonds worth $507.71 billion.

ETF managers attempt to re-create their benchmark indexes through a process known as quantitative sampling.

That means breaking the bonds in the index down into risk categories, such as call features, duration, and credit risk.

The manager then selects bonds by category so the trust’s risks approximate the risks of the index.

Two things can go wrong. Either the trust’s assets can fail to replicate the index, or the stock price can fail to replicate the assets in the trust.

ETFs suffered both during the worst of the credit crisis.

Take the SPDR Barclays Capital Municipal Index fund, which with $758.8 million in assets attempts to ape the Barclays Capital Municipal Managed Money Index.

In the first year after its September 2007 launch, the stock mismatched the trust’s assets by more than 1% only four times, the worst being a 2.6% unhinging in March 2008.

Then came the liquidity crisis, and everything became unglued. The stock missed its trust’s assets by more than 1% five times in November alone, including an unmooring of more than 7% and another of more than 6%.

The stock mismatched its assets in December seven times, four times by more than 6%.

Most funds saw their worst tracking errors in the months after the Lehman bankruptcy. Some investors were forced to sell their stocks, regardless of the value of underlying assets. Some investors anticipated the indexes would be falling, and tried to sell their ETFs in advance. And other investors were simply gripped by panic.

“You basically saw more volatility in the muni markets, and so we saw more tracking error in our funds versus their respective benchmarks,” said Matt Tucker, head of U.S. fixed-income strategy at Barclays Global Investors.

Conditions have eased since then.

For instance, Barclays’ iShares national fund suffered through 40 days in the fourth quarter of 2008 when the stock missed its assets by at least 1%.

The stock has clung to its assets within 1% every day since the beginning of June.

The SPDR Barclays Capital national fund has not strayed from its assets by more than 1% since March. Its short-term fund, the SPDR Barclays Capital Short Term Municipal Bond fund, has missed its assets by more than 1% 37 times, all but one of them in the six months following Lehman’s bankruptcy.

“It would seem to be that the [worst of the tracking errors] are behind us,” said Timothy Ryan, a portfolio manager for State Street Global Advisors, which runs the SPDR funds. “I think the tracking’s been pretty decent even through that time, which was unusual.”

“There has been generally an easier move toward replicating an index just because the market has freed up in terms of liquidity and interest,” said James Colby, municipal strategist at Van Eck Global, which runs the Market Vectors suite of ETFs.

“The softening of the views of buyers and participants toward the economic recovery has made for more liquid markets and made it a little bit easier for us to find the bonds that are an appropriate match to what we need, and improving our ability to track our indexes. Liquidity in the marketplace only enhances our ability to do what we want to do.”

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