The Numbers Are In And The Winner Is...

September 17, 2007

Aguilera offers a real-time comparison on the two listed muni ETFs.

Individual investors. I cannot overemphasize this point. Exchange-traded funds (ETFs) are democratizing municipal bonds by shedding light on the shadowy period between a bond’s issuance and its maturity date. True to form, they are doing so with transparency and liquidity in a low-cost manner.

Now that both funds are trading, I was able to compile the following information:

Even though these funds were just launched, I think it is important to focus on the composition of the funds, rather than the characteristics of their associated indexes. As Matt previously mentioned, whenever you employ representative sampling, you run the risk of tracking error. Fortunately, the number of holdings in these funds will ramp up as the assets flow in.

For those who attended yesterday’s webcasts, they were a study in contrast. The Barclays call was direct and to the point, focusing on the merits of the product by utilizing 11 slides. State Street’s webcast was broader in scope. They began by establishing the need for the asset class, following with insights into the municipal market and concluding with the merits of their offering. I’m not discounting either method. They were both excellent calls. As you can imagine, the State Street call lasted about twice as long as the Barclays call. State Street deserves a round of applause for spending well over 20 minutes fielding questions from attendees.

The calls confirmed my previous statements regarding the distinct creation/redemption methods employed. Barclays feels they have an advantage with their separate baskets, optimized for liquidity on the creation side and tax-efficiency on the redemption side. State Street prefers to utilize cash as the primary creation mechanism, while maintaining the in-kind redemption feature to ensure tax-efficiency. It is worth noting that this isn’t the first ETF to employ cash as the preferred creation vehicle. In an interesting side note, Barclays currently makes use of cash during the creation process for its Taiwan (EWT), Malaysia (EWM), South Korea (EWY) and Brazil (EWZ) funds due to country-specific trading restrictions on in-kind transfers.

Current holders of the iShares Lehman Aggregate Bond Fund (AGG) and the SPDR Lehman Aggregate Bond Fund (LAG) might be interested to know that cash is already employed during the creation process for TBA (To Be Announced) positions, which are placeholders for Mortgage-Backed Securities (MBS). As an example, 33.86% of the Lehman Aggregate is comprised of MBSs, while representing 41.43% of the AGG. Fortunately, unlike munis, the TBA market is highly liquid and transparent. In fact, in the AGG, the Authorized Participant (AP) foots the bill for the transaction costs incurred by the fund.

So what is State Street’s rationale for having the fund purchase the securities during the creation process? They were concerned about the ability of certain parties to front-run the fund in a highly fragmented marketplace. This is a very valid concern, but I think Barclays’ approach effectively negates any front-running since the fund can modify the creation basket on a daily basis. Furthermore, I expect both funds to focus on new issues during the creation process, which will significantly lower transaction costs. Speaking of which, by employing cash as the primary vehicle for creations, State Street’s fund will bear the transaction costs of acquiring the bonds. Keep in mind, State Street’s sheer size and presence will command far better pricing, largely avoiding the 2% transaction costs experienced by individuals in a 2004 study conducted by the SEC.

Given how the products are priced, it is obvious that State Street has its sights set on the individual investor. I for one still hold a small grudge against Barclays for announcing share splits in 12 popular funds back in 2005. Most investment managers prefer higher share prices since they operate on per-share ticket charges. Granted, commission costs are miniscule, but splitting a fund creates no value and doubles the per-share ticket charge. Therefore, I prefer to see a higher share price. Further evidence of a retail emphasis can be seen in the fund’s symbol TFI, which stands for Tax-Free Income. In an interesting twist of irony, veterans of the wirehouse world have long used TFI to denote Taxable Fixed-Income.

Given the large seeding and unique structure, I still believe that Barclays' MUB has the edge over State Street's TFI. However, the marketplace will crown the eventual winner. The truth is the $378 billion in municipal bond mutual funds would be far better off in these two ETFs, where shareholders are insulated from the actions of their fellow shareholders. Regrettably, traditional municipal bond mutual funds suffer from cash drag while they continue to distribute capital gains as the result of fund sales to meet shareholder redemptions.


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