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(Bloomberg) — Market volatility has boosted municipal bond exchange-traded fund growth through 2022 at the expense of higher open-end mutual funds, which may lose some assets for good.
Despite the worst market crisis in 40 years, investors plowed a record $27.8 billion into municipal bond ETFs this year, a sharp contrast to open-ended funds that lost more than $130 billion. About half of the revenue came from losses from mutual fund owners selling shares to offset gains and switch to ETFs, according to Drew Pettit, director of ETA analysis and strategy at Citigroup Inc.
Municipal bond investors, reluctant to exit mutual funds due to capital gains during the bull market, have seen the muni market lose 8 percent this year as the Federal Reserve raises interest rates the fastest in decades. Historically, poor returns have provided tax-savvy municipal bond investors with the opportunity to harvest losses.
Low transaction costs and the adoption of model portfolios by investment advisers means that many assets acquired through muni ETFs remain, Pettitt said. This year’s inflows of muni ETFs were more than double the average of the past three years, bringing total holdings to $105 billion.
Collecting tax losses “was a key incentive to help move the flow and volume of wealth,” Pettit said. “Once people buy a product, it becomes a little sticky in their portfolio, especially if they’ve had a good shopping experience.”
Very high
Under tax rules, investors must switch to a similar, but not very similar, security for 30 days to offset income. The largest ETFs benefited the most.
Vanguard Group Inc’s, Tax-Exempt Bond Index ETF gained $10.9 billion, while BlackRock Inc’s iShares National Muni Bond ETF attracted $9 billion, or 70% of the category’s growth.
Citigroup estimated the impact of tax-loss accumulation on ETFs by matching weekly periods of muni mutual fund outflows to inflows into ETFs and comparing flow trends over the past two years.
These income streams were much higher than the slow and steady profit trend of the past two years during this year’s bear market. Citigroup estimates that approximately 25% to 50% of its investments in municipal bond ETFs come from mutual fund counterparts.
Muni ETFs are also benefiting because investors are focused on all fees, not just management costs, Pettitt said.
Transaction costs
Transaction costs for muni ETFs with more than $200 million in assets are just 0.11%, which is lower than the bid-ask for institutional-sized bond trading businesses, according to Citigroup. For unusual blocks of $10,000 to $25,000, the spread ranges from 0.28% to 0.55%, according to the bank.
“When I buy an ETF, I might face someone on the stock exchange that day, and that spread is very tight,” Pettitt said.
In the year Laws that took effect in 2018 requiring brokers to disclose to clients how much they charge for municipal bond trades have brought more scrutiny to trading costs by investment advisers, he said.
The adoption of model portfolios by investment advisors and their clients is contributing to the growth of muni ETFs, according to Citigroup. Model portfolios, purchased from investment platforms, leveraged ETFs and other funds with customized strategies that adjust based on risk appetite and market movements.
Model portfolio managers such as FMR LLC Strategic Advisors, Wealth Fort Advisors and Creative Planning are among the holders of Vanguard’s and BlackRock’s muni ETFs, securities filings show.
Products like automated, off-the-shelf products allow advisers to focus more on client relationships, Pettit said.
“As model portfolios get their teeth into an ETF or a group of ETFs, you start to see a steady, steady trickle of money coming into these products,” Pettit said in an interview. “And it’s hard to pull that off.”
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