Most muni bond exchange-traded funds performed noticeably worse in the fourth quarter than the indexes they were designed to track.
Whether this underperformance is a black mark on the still-young municipal ETF business requires interpretation.
"Tracking error" — the term ETF managers use for mismatches between ETF returns and returns on a target index — was substantial in the quarter as shares representing ownership of trusts filled with municipal bonds were dumped more severely in the equity market than were the bonds themselves.
Shares of the iShares S&P National AMT-Free Municipal Bond Fund — which, with $1.91 billion of assets, is by far the biggest muni ETF — underperformed their benchmark index by 137 basis points in the quarter, according to a Bloomberg LP total return calculation that assumes reinvested dividends. Van Eck Global's high-yield muni fund's shares missed their target index by 150 basis points.
Though ETF managers are never happy about failing to track their indexes, some assert a possibility that the ETF market's turmoil better reflected the municipal bond market's illiquidity and an evaporation of demand than the indexes themselves did. In other words, the funds underperformed their indexes because the indexes were too slow to reflect how bad conditions were in the municipal market.
"Muni ETFs definitely seem to be precursors, reflecting expectations of the muni market, especially in the fourth quarter," said Phil Fang, who manages the municipal ETFs at Invesco PowerShares. "We believe that muni ETFs can reflect the expectations of the muni market ahead of it."
With that consideration, municipal ETFs' more dramatic selloff may have presaged further weakness in municipal bonds, as well as manifesting weakness in the bond market that was not yet showing up in indexes.
The muni market includes more than 60,000 issuers and at least 1.2 million Cusip numbers. But munis are considered less liquid than Treasury or corporate bonds, and the more drastic selling in the ETF sector may have reflected what a lack of activity in the municipal bond sector belied, and what failed to appear in the indexes.
"You certainly could make an argument that share prices fairly represented value for the underlying asset class," said James Colby, a senior municipal strategist at Van Eck. "In [the] absence of seeing real Municipal Securities Rulemaking Board print trades for cash bonds, we actually have a proxy for munis, and that is the tradeable equity ETF that represents the particular muni index."
Obviously, not all tracking error is a premonition, but in many cases ETF shares respond faster to changes than municipal bond indexes do.
"The authorized participants that are trading these vehicles are savvy enough to understand what the cash bond market is like, even if they're not trading cash bonds," Colby said. "The share price is a pretty good proxy for that cash market."
Invesco's Fang said one reason the ETF share market might be quicker to reflect changes in the municipal marketplace is that it is easier to trade ETFs than municipal bonds or mutual funds. ETFs also have specialists devoted to making markets in the shares, and they enjoy greater institutional participation than the retail-centric municipal bond market.
"Because of the efficiency of ETFs, people wanting to make a bet on the market may feel that with muni ETFs it's a lot easier for them to say, 'We think the muni market will underperform' and trade on that conviction," Fang said.
