Money Management Executive
Municipal bond exchange-traded funds have gone from zero to 60 miles an hour in just a few days, and the race to enter the market continues.
Two weeks ago there were not such funds in the investment marketplace. But last week both Barclays Global Investors of San Francisco and State Street Global Advisors of Boston began trading their versions of the products.
PowerShares Capital Management LLC, a unit of Invesco PLC, announced last month that it expects to begin trading two funds in October — an insured and a noninsured national municipal bond ETF, both based on Merrill Lynch & Co. bond indexes. Van Eck Associates Corp. of New York is readying six funds for its Market Vector ETF Trust series: three national ones with varying durations, a high-yield one, and two single-state ones focusing on California and New York.
Why the rush to debut municipal bond ETFs? Ego has played a part. Each firm was vying for the bragging rights of being the first to offer one; Barclays beat out State Street by two trading days.
At the end of July there were only 30 fixed-income ETFs, versus six at the end of 2006. By contrast, there are currently 509 equity ETFs. State Street Global Advisors, which launched the very first exchange-traded fund, the Standard & Poor's Depositary Receipts (or SPDRs), back in 1993, launched five bond products in May.
Secondly, the demand among investors for a municipal bond ETF has been fierce over the past few years.
"Munis have been one of the single most requested ETFs by advisers for the past five years," said Anthony Rochte, senior managing director at State Street Global Advisors.
The lack of transparency within the bond market also has contributed to increased demand for municipal bond ETFs, he said. Last week State Street Global Advisors created its SPDR Lehman Municipal Bond ETF, which tracks an index that Lehman Brothers created in June 2004.
Demand has been strongest among financial and registered investment advisers, who have been seeking a lower-cost alternative for their clients to traditional municipal bond funds, whose expense ratios average at least five times that of the 20 basis points charged by the new State Street fun, Mr. Rochte said.
He estimates that 40% of State Street Global Advisors' ETF audience is made up of financial advisers, with another 50% to 55% coming from institutional investors and rest from self-directed investors.
"We think there's an appetite in each segment for muni bond ETFs," he said.
Investors' needs also were in the forefront of executives' minds at Barclays Global, which debuted its iShares S&P National Municipal Bond Fund on Sept. 11.
"Investors have been looking for a simple and cost-effective method of gaining exposure to the municipal market, which is traditionally a less liquid and expensive marketplace," said Noel Archard, head of U.S. iShares product development, said when the fund was unveiled.
A Barclays spokeswoman said that the fund "provides individual investors and their financial advisers with more tax efficiency, transparency, and lower costs than traditional mutual funds."
Individual investors who historically have bought individual bonds now can diversify and have national exposure with a single trade, the spokeswoman said. Institutional investors "value the ability to short the ETF as a hedging vehicle for other municipal exposure, something that has never been done before."
The new iShares fund is also very significant in that its underlying index is a brand new one from Standard & Poor's Corp. — its first in the fixed-income world and the first in a series of U.S. fixed-income indexes that S&P plans to introduce.
The new index includes about 3,000 municipal bonds that S&P has culled, according to specific criteria, from its much broader, but not investable, Standard & Poor's/Investortools Municipal Bond Index of 50,000 issues. As of Sept. 4 the bonds in the newly created index had a market value of over $305 billion.
Why did S&P dive into the fixed-income index market? "There's no reason for us to feel restricted to equities," said David Blitzer, managing director and chairman of the index committee at the agency. "We think this is a very important contribution to municipal bond trading."
In recent months S&P has created other indexes, including two real estate ones.
"Fixed income is a huge market, with the total amount outstanding bigger then the equity market," Mr. Blitzer said, and fixed-income indexes that will provide liquidity work well to support exchange-traded funds.
S&P will be carving out more narrowly focused indexes shortly for California and New York municipal bonds, and it will be looking at indexes for other states with high income taxes, he said. In addition, "we are looking at various other areas of fixed income — other segments that are unserved and will support investment services."
As for whether the market really needs an array of municipal bond ETFs to satisfy its appetite, the jury is still out.
The introduction of such products is a reflection of the ETF industry in general. That could be particularly important for those who want to hold and trade a 100% ETF portfolio, said Sonya Morris, editor of the Morningstar Inc. newsletter Morningstar ETF Investor.
The ETF industry is now courting more individual investors and registered investment advisers who want to incorporate such funds into their portfolios, Ms. Morris said. However, she is taking a wait-and-see approach as to who will win the municipal bond ETF turf war.
"It will be interesting to see what happens in five years," she said.