By
Morningstar
:
By Timothy Strauts
Something strange appears to be going on with municipal-bond
exchange-traded funds. The two largest ETFs in the category have
had very different performances for the year to date. iShares
S&P National AMT-Free Municipal Bond ETF (
MUB
) has returned 4.90% this year. Its main competitor, SPDR Nuveen
Barclays Capital Municipal Bond ETF (
TFI
), has returned only 2.19%. Both ETFs track investment-grade
municipal bonds, have similar yields and durations, and have fees
that are within 2 basis points. From a holdings perspective, the
only material difference is the slightly higher credit quality of
TFI, but even that difference is negligible.
Why would similar funds have such different results and what
should investors do? Upon further investigation, we find that what
appears to be strange is in fact what we should expect, and the
course of action is simple.
It's Not You, It's Me
I am an advocate for well-constructed funds, so it pains me to say
this: It's time to part ways with MUB. This recommendation has
nothing to do with our outlook for the muni-bond market. It just
boils down to returns. MUB has been trading at a substantial
premium to its net asset value lately, a phenomenon more frequent
in closed-end funds than in the ETF marketplace. However, TFI is
still consistently trading near its NAV. So, if the fund
characteristics are so similar yet one is trading at fair value and
the other is trading at a 3% to 4% premium, why wouldn't you swap
them? The premium is almost double the current SEC yield of
approximately 2%.
I do feel slightly guilty about making this recommendation since
the iShares fund has served investors well. In fact, it has served
as a better tool for accessing the muni-bond market than TFI. The
ETFs have had very similar performance until recently when MUB's
returns surged ahead. Once the premium on MUB disappears, which
will most likely happen in the near future, feel free to swap back
if you'd like. You'll set yourself up to capture the premium (or
discount, depending on market conditions) again in future
years.
You have to venture into the ETF sausage factory to see why the
performance gap has emerged recently, and the research is worth the
result. You'll find that it is completely logical for temporary but
sizable premiums to occur on MUB while TFI stays close to its NAV.
However, you'll also find that MUB will likely have better NAV
performance over longer periods of time because the fund incurs
lower trading costs. These lower trading costs could manifest into
substantially higher returns if TFI realizes substantial fund
inflows during periods when the muni-bond market is trading
inefficiently, as it is today.
Municipal Market
All ETFs trade as a function of their underlying market, and the
current municipal-bond landscape is supply constrained. In January
there was $7 billion in inflows to muni mutual funds and ETFs,
which is a turnaround from 2011 when there was $9.8 billion in
redemptions. To make matters worse, new issuance of individual muni
bonds in January was anemic. Thus, we've seen outsized demand by
new investors precisely when supply of new bonds has been
limited.
Another factor that is limiting liquidity is that some major
muni-bond dealers are holding less inventory than they have in the
past. The infamous "Volcker Rule" seeks to reign in risk-taking by
limiting the proprietary trading at banks. Maintaining an inventory
of bonds available for sale is considered proprietary trading so
the major dealers have started reducing the size of their inventory
in anticipation of the new rule. While many speculate that the rule
will not be implemented in its current form, the fear of the law's
current structure is enough to curb market participation. The net
effect of these three factors has created a situation where the
bid-ask trading spreads on bonds have widened dramatically.
The Sausage-Making Process
The process that keeps an ETF trading near its net asset value is
the creation/redemption process. Without the creation/redemption
process, ETFs would simply be closed-end funds. Institutional
trading firms called authorized participants are the ones who work
with the ETF provider to handle this process. If there is strong
buying demand for an ETF, then it will trade at a premium to its
NAV. However, when the premium gets to a critical level, it will
become profitable for an authorized participant to arbitrage the
premium away. To eliminate a large premium, more shares need to be
created to satisfy market demand. This is when the APs aggregate
and deliver a predetermined basket of bonds, called a creation
basket, to the ETF provider. In return for the basket of
securities, the ETF provider gives back shares of the ETF. The AP
then sells the newly created ETF shares to buyers on the exchange
for a slight profit. With the extra demand for shares satisfied,
the ETF will trade back near its net asset value.
MUB and TFI both hold hundreds of different bonds in their
portfolio. It would be very difficult for an AP to buy up hundreds
of illiquid bonds to do a simple creation, so ETF providers
typically have a creation basket that is substantially smaller than
the index. For an ETF with 500 securities, this creation basket may
consist of only 10 to 40 bonds. Under normal market conditions, it
is relatively easy to buy the bonds in the basket. But as we
identified earlier, the current supply-constrained market has made
it much more difficult.
In an illiquid market, fixed-income ETFs can trade at
substantial premiums because of increased trading spreads. ETFs
calculate their net asset value based on the market "bid" price. To
create new shares to meet demand, APs have to buy bonds at the
"ask" price of the market. This difference between the bid and the
ask in the muni market is well over 2% right now. If APs are paying
2% more to create shares they are going to pass that difference
down to investors and you'll see it as premium in the ETF.
Two Different Approaches
Relative to the rest of the industry, the folks over at iShares are
the staunchest ETF purists. Whenever possible, they stick to a
consistent creation/redemption process where they receive only
physical underlying shares for their funds--along with enough cash
to make up for rounding differences and accumulated dividends or
interest. However, not every firm follows this model. Many ETF
providers operating in less-liquid markets will accept cash in lieu
of securities, thus performing a "cash creation."
Cash creations are nothing new. (You could argue that every
open-end mutual fund "creates" new units through the cash process.)
When State Street teamed with Nuveen to create TFI, they had an eye
on flexibility. From time to time, the fund provider will accept
either securities or cash from authorized participants to create
new shares. Why do they allow this?
Because it is so difficult to aggregate muni bonds right now,
authorized participants have to pay considerably higher prices than
the index actually indicates they are worth. Thus, the flexibility
lowers costs for the APs. This results in the ETF trading at a
smaller premium to NAV than a fund that uses in-kind
transactions.
On its face, it seems that allowing flexibility in the creation
process has a lot of upside. In reality, the flexibility is a zero
sum game. The perceived benefits are really just a transfer of
wealth from one set of investors to another. In our case, investors
who purchased TFI several months ago are subsidizing investors who
choose to buy it today. This is one of the few cases where even a
free-market proponent should love subsidies.
The cost of purchasing the muni bonds is simply shifted away
from the APs and onto the owners of TFI. Any new cash that flows
into the fund will eventually be used to purchase muni bonds on the
open market. If we assume that TFI's traders are equally efficient
at trading bonds as the APs are, then the net purchases will occur
at a premium to the index level. Thus, each incremental dollar put
to work will cause the fund performance to lag by the amount of the
premium.
When TFI accepts a cash creation the portfolio manager will need
to go the market and buy municipal bonds directly. If the market is
illiquid the manager will have to pay the elevated ask price of the
market. This premium is a cost borne by all shareholders in the
fund instead of just the new purchaser in the case of the iShares
ETF MUB.
Because muni bonds are trading inefficiently, they are
exhibiting a hefty liquidity premium. If you are curious about how
liquidity can impact returns, check out "Liquidity as an Investment
Style" by Ibbotson, Chen, and Hu.
For How Long?
The final catch is an important one. In the highly likely event
that the liquidity of the municipal-bond market reverts to its
average, we would consider switching back to MUB. Why the flip-flop
from the stodgy buy-and-hold folks at Morningstar? Well, it's all
about performance.
IShares is very strict about the bonds it will allow in the
creation basket which helps the fund maintain very accurate index
tracking. If you look at Morningstar's Estimated Holding Cost data
point, MUB costs 0.33% per year to hold. Most of the holding cost
is the expense ratio of 0.25%. If you exclude this cost, MUB has
displayed a tracking error of only 8 basis points. This is
tremendous tracking when you consider that MUB tracks a very broad
index of more than 8,000 bonds. The downside to very accurate
tracking is that premiums can develop in your ETF when the market
becomes illiquid.
The upside to the in-kind creation process is that MUB will
likely exhibit even better tracking than TFI over the long term.
Because the high-cost of purchasing new bonds is not included in
the index today but will manifest in NAV performance over time, we
would expect this to result in a performance drag going forward if
a substantial amount of funds flow in during this period of
muni-bond market illiquidity. It's one of the few cases where we
will be able to attribute predictable tracking error to fund
flows.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
Don't Surrender The CAPE
on seekingalpha.com