Barclays Global Investors (BGI) was first out of the gate on Monday morning with MUB—the first municipal bond exchange-traded fund (ETF). The fund was seeded with $300 million, which is impressive in a market environment where new ETF launches have been seeded with as little as $5 million. As we all know, liquidity is the lifeblood of ETFs, and $300 million is quite an infusion.
The management fee on MUB is pegged at 25 basis points, which is a bargain compared to the 102 basis points charged by the average open-end municipal bond mutual fund. However, embedded in the footnotes is a contractual agreement to waive a portion of the management fee through June 30, 2008. If the agreement is not renewed, the management fee will increase by 5 basis points, which represents a 20% increase to 30 basis points (0.30%). This was a clever move by BGI since the new muni bond ETFs will all compete on the basis of price and yield when launched. Nevertheless, I have never heard of an ETF increasing its expense ratio despite the existence of similar fee waivers with other providers.
A fee increase would defy conventional logic, which dictates that economies of scale should yield lower, not higher, fees. DBC is a perfect example. When the fund launched, the expense ratio was an oppressive 1.9%. Once the initial expenses associated with the launch were recouped, subsequent fee cuts brought the expense ratio down to 83 basis points. If Barclays were to raise their management fee, that may spark a trend in which ETF powerhouses underprice their products at launch to drive out competition. That being said, I doubt Barclays will raise their management fee once the fee waiver lapses. I view this footnote as a backup should the fund fail to garner the requisite assets under management.
With that news tidbit out of the way, let us look at the fundamental differences between the various municipal bond ETFs. As I previously stated, many investors will focus on the expense ratios when comparing these offerings. Evaluating funds on the basis of cost is an important step, but it is just the first step in a process that must account for the internal expenses of the fund, which are not readily disclosed.
Advisors have been clamoring for a muni ETF since the first fixed-income ETFs were brought to market four years ago. Unfortunately, the municipal bond market is highly fragmented with significant friction costs. Up until now, these two constraints have hampered the development of a municipal bond ETF since specialists must have the ability to create and redeem sufficient quantities of ETF shares to meet order flows. If the creation/redemption process is not fluid, large spreads will arise, eating into the returns of investors. Therefore, let us begin by evaluating the unique processes each firm has instituted to facilitate the creation/redemption process.
The Importance Of The Creation/Redemption Process
Barclays is the granddaddy of the fixed-income ETF world, having launched the first fixed-income ETFs in 2003. Like the other providers, they employ representative sampling to construct a portfolio that is analogous to its corresponding index. However, two unique optimized baskets are employed to facilitate the creation/redemption process. The creation basket is liquidity-driven and meant to track the fund and not the underlying index. With that in mind, liquidity is just one of the factors that are accounted for in the proprietary scoring algorithm (credit quality, duration, etc.). The fund will launch with approximately 30 securities, out of a possible 3,069 constituent securities in the S&P Index. Interestingly, the creation basket will also contain approximately 30 securities at launch. While there will be a significant amount of overlap between the funds' holdings and the initial creation basket, the composition of the creation basket will change to allow the fund to ramp up the number of issues held. Given sufficient asset flows and the luxury of time, the fund could easily swell to a multiple of its current number of holdings. The redemption basket takes its cue from the creation basket, employing a proprietary algorithm driven by tax-efficiency, which sorts the holdings based on unrealized capital gains. Overall, this is a formidable offering from the pioneer in fixed-income ETFs.
Van Eck's entries are not only unique, but also innovative enough to merit an application for a patent. Their novel approach gives Authorized Participants (AP) discretion during the creation process by disseminating a daily list of permissible characteristics based on credit rating, sector, issuer, duration, maturity, coupon yield and liquidity. In essence, the AP can assemble a stratified sample basket that may or may not contain component securities of the index. The AP will then deliver this stratified sample basket to the fund, which retains the authority to accept or reject the basket. There is no question that this structure will enhance liquidity since APs will not have to scour trading desks for difficult-to-source munis. On the other hand, APs are for-profit enterprises that will go out and find the cheapest possible way to deliver a basket that meets the designated characteristics. Could this lead to a disconnect between the underlying index and the composition of the fund? In theory yes, but since the fund can modify the list of required characteristics at anytime, I would say no.
It is my understanding that State Street and PowerShares are utilizing cash to facilitate the creation/redemption process. While this may change prior to launch, State Street appears to handle creations on a cash basis and redemptions on a security basis, whereas PowerShares will be utilizing cash as the primary vehicle for both creations and redemptions. Utilizing cash creates a number of obstacles that could lead to wider spreads. Unfortunately, since the fund will be responsible for deploying the cash, transaction costs will be borne by the fund. Moreover, one of the hallmarks of ETFs' tax-efficiency has been the in-kind transfer mechanism during the redemption process, which allows the fund to kick out low-cost-basis securities. Without the benefit of an in-kind transfer, funds would be forced to recognize gains during the redemption process. State Street has done a wonderful job supporting the SPDR franchise and I hope that I am overlooking something that would make their offering as attractive as those sponsored by Barclays and Van Eck. The same can be said for PowerShares, which has developed a strong and enviable reputation for pushing the ETF envelope.
Differences And Similarities
Moving beyond the creation/redemption process, how do these funds differentiate themselves from one another? Well, the obvious disparities arise from their selection of the underlying indexes they will track. ETF veterans may find it odd that Barclays, which built its fixed-income ETF lineup on the back of Lehman indexes, selected an S&P index. From what I hear, they worked closely with S&P to create this index, which represents their estimate of the investable municipal bond market. State Street and Van Eck are utilizing essentially the same preexisting Lehman indexes for their municipal bond exposures, with State Street taking a broader approach and Van Eck breaking the index into its various subcomponents (short, intermediate, etc.). PowerShares turned to Merrill Lynch to develop an index that would help differentiate their offerings from their competitors. Unfortunately, since both the index and product are yet to launch, information is scarce.
There is also a surprising amount of commonality. All four firms have filed for state-specific funds covering California and New York. As we all know, interest from municipal bonds is exempt from federal taxation. Moreover, most states exempt income from munis issued within their state from state and local income taxes, which is why you see the focus on California and New York. But an interesting wrinkle lies on the horizon. In January of last year, the Kentucky Court of Appeals maintained that the state's exemption of interest income on its own bonds unlawfully discriminates against interstate commerce. The Supreme Court agreed to review the decision earlier this year, so we can expect a ruling during the high court's next term. If the Supreme Court agrees with the opinion of the Kentucky Court of Appeals, shockwaves will be felt throughout the municipal bond landscape.
Some other interesting observations drawn from the preliminary prospectuses include the ability to go "off-index" by up to 20%. I think the firms will use this cushion to reduce volatility and transaction costs by holding bonds to maturity. As an example, the S&P index utilized by Barclays drops municipal bonds from the index when they have a month left to maturity. Barclays will more than likely hold the bonds to maturity rather than being forced to liquidate them in the murky waters ruled by the municipal bond desks. While we are on the subject of Barclays, it appears that approximately 60% of the fund will be comprised of insured municipal bonds, which may be a marketing blow to PowerShares' Insured National Municipal Bond Fund. This reiterates the importance of looking beyond the name of a fund for a more accurate depiction of its holdings.
In my opinion, these ETFs are a welcomed addition because they will bring transparency to a market that is notoriously opaque. Just go to investinginbonds.com and look through the order executions of the municipal market and you will see spreads that look as wide as an eight-lane interstate compared to the jogging trails that are ETF spreads. I sincerely believe that the individual investor will be the real beneficiary of this latest financial innovation.
Some might say having four firms simultaneously introducing funds targeting the same asset class is a recipe for disaster. Sure, liquidity might be cannibalized with so many choices, but I value the freedom of choice. Moreover, having several options available frees up the possibility of establishing highly correlated replacement positions while harvesting losses for tax purposes. Now, for those that know me, I am a tax-loss harvesting zealot. You should be aware that municipal bond ETFs introduce some complexity to the loss harvesting process. Allow me to elaborate on the constraints placed on recognizing losses when exempt income is received.
Picture an extreme example in which you purchase a municipal bond ETF just before it distributes an exempt interest dividend of $2,000. Upon receiving the exempt dividend, you sell the ETF position and claim a short-term capital loss of $2,000. Sounds like a great deal. After all, you received $2,000 in exempt income and you got to claim a $2,000 loss. Well, don't even think about trying this unless you want an auditor knocking on your front door. The tax code requires you to hold your shares for a minimum of six months before recognizing a short-term capital loss in its entirety. If you were to sell your shares within six months of purchasing them, any loss up to the amount of exempt income received would be nondeductible. In the previous example, any loss recognized within six months up to $2,000 would be nondeductible. However, any amount over $2,000 would be classified as a short-term capital loss.
As I previously stated, these funds will all compete on the basis of price and yield. While the eventual low-cost leader will have a distinct advantage, potential investors will be far more likely to focus on yield. With that in mind, investors should utilize the 30-day SEC yield to calculate a tax-equivalent yield, which is just the 30-day SEC exempt yield divided by 1 minus their tax bracket. This will give them some perspective when comparing the municipal ETFs alongside taxable fixed-income alternatives. Accordingly, investors in the highest tax brackets (28%, 33% and 35%) are the most likely to benefit from these tax-exempt ETFs.
As an aside, investors should understand that only the income received from these funds is exempt from taxation. Any gain associated with the sale of shares is subject to capital gains tax rates. One other point of note, since the income received is exempt from taxation, investors need to hold these funds in taxable accounts. Otherwise, the primary benefit of holding these securities is negated.
For those not relying on their portfolio for income, they will be better served by focusing on traditional taxable fixed-income securities placed in tax-deferred accounts (IRAs, 401(k)s, etc.) where they can avail themselves of higher yields. On the other hand, investors who depend on their portfolios for income will find these municipal ETFs a welcomed addition to their toolbox when constructing a tax-efficient income stream from their portfolio.