Vanguard Tackles the Pitfalls of Muni Indexing

A version of this article was published in the January 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

In August 2015, Vanguard launched the market's first tax-exempt index open-end mutual fund, which also featured an exchange-traded fund share class. Prior to the launch, there were only a handful of broad-based muni index ETF options available to investors and no open-end index mutual funds; many managers cited the muni market's diverse and fragmented nature as challenges to successful indexing.

Here I'll address the challenges of constructing a muni index fund and examine the specifics of Vanguard's fund, as well as other passively managed muni strategies on the market.

Muni Indexing: The Challenges Although a handful of muni index ETFs have garnered more than $1 billion in assets, assets in indexed muni-bond strategies account for just a tiny share of the total $600 billion in muni funds across Morningstar's ETF and open-end fund universe. Vanguard is the first to bring an open-end muni index fund to market. That's not surprising, given that the muni market poses several challenges to those seeking to track an index.

The first set of challenges isn't unique to muni bonds. Broad-market fixed-income indexes often contain thousands of bonds, making it impractical for an index fund to own every bond in its benchmark. Instead, these funds employ sampling techniques to build portfolios that they feel best represent the characteristics of the bonds in their index. Managers consider a bond's maturity profile, credit quality, tax implications, and call features, among other factors, with the goal of creating portfolios that are broadly representative of their benchmarks. How well a fund replicates the characteristics of its target benchmark is reflected in its tracking performance (as measured by tracking error and tracking difference). As an index fund's assets grow, it can own a larger number of the securities that comprise its benchmark. This will better align a fund's portfolio with its index, thereby--at least in theory--improving tracking performance.

Munis pose an additional set of challenges for would-be indexers. For starters, the muni-bond market is particularly diverse and fragmented, making the sampling process tough. The sheer volume of issuers alone can make replicating a specific segment of this space difficult. The $3.7 trillion muni market includes well over a million individual bonds outstanding that are offered by more than 50,000 unique entities, including many small and infrequent issuers. In contrast, the Barclays U.S. Aggregate Bond Index tracks a market of roughly $17.6 trillion, with fewer than 1,500 issuers.

Furthermore, trading volumes in the muni market are lower than in the taxable space, limiting the liquidity of even the higher-quality and more frequently traded issues relative to the taxable market. According to the Municipal Securities Rulemaking Board, the average number of unique municipal securities traded on a daily basis is modest at between 10,000 and 20,000.(1) The relative illiquidity of the muni market can be explained in part by the composition of muni bonds' investor base. According to the Securities and Financial Markets Association sourcing data from the Federal Reserve System, more than 40% of muni bonds, or nearly $1.6 billion in muni debt outstanding, is held by individual retail investors.(2) Retail investors are more likely to hold these bonds to maturity and are thus unlikely to sell them prior to maturity. This further reduces liquidity and makes certain bonds difficult to source.

In August 2015, Vanguard launched the market's first muni-bond index mutual fund, Vanguard Tax-Exempt Bond Index VTEAX, and Vanguard Tax-Exempt Bond ETF VTEB, an exchange-traded share class of the mutual fund. Muni indexing isn't a new concept for the firm. Vanguard had filed to launch three new muni index funds several years ago, and representatives argue that it had the mechanics in place to successfully track the indexes at that point. However, Vanguard withdrew the request with the Securities and Exchange Commission in January 2011 amid market turbulence and outflows. Volatile market conditions and a surge of outflows didn't augur well for a successful muni index fund launch. More recently, muni market conditions have stabilized, as investors have returned anew to muni funds in 2014 and 2015 amid improving issuer fundamentals and receding headline risk. This should allow a newly launched index fund to build assets more quickly and therefore better track its index.

While relatively stable market conditions go a long way toward answering the question of "Why now?", client demand was also an important factor. Ultimately, Vanguard notes that the launch of the fund was a response to a growing number of requests from clients looking for passive exposure to the muni market. Also, the ETF share class opens up a wider distribution network for investors interested in the strategy.

Run by muni portfolio manager Adam Ferguson, the fund tracks the S&P National AMT-Free Municipal Bond Index, a broad, market-value-weighted index designed to mirror the performance of the investment-grade muni market in the United States. By design, this benchmark focuses on the muni market's most liquid issuers.

Given the benchmark's emphasis on larger, more-liquid, high-grade issues and a duration that's currently running longer than the muni national intermediate Morningstar Category norm, Vanguard's fund will likely be more interest-rate-sensitive than the typical intermediate-term muni fund. Over time, it's expected that the fund's duration, a measure of overall interest-rate sensitivity, will land between five and eight years.

Weighing the Options: Muni ETFs Until the launch of the Vanguard Tax-Exempt Bond Index fund, passive investment options for muni investors consisted exclusively of ETFs with a municipal focus. As of the beginning of March 2016, 34 muni ETFs appeared in Morningstar's database. Of these 34 ETFs, 29 were passively managed, while the remaining five were actively managed. Only a handful of these funds offer broad-based coverage of the muni market and have garnered more than $1 billion in assets to date.

The largest of these is

Since its Sept. 7, 2007, inception, MUB's average total return of 4.5% per year (through Feb. 29, 2016) carries a modest average annual tracking error, indicating that the fund is performing as expected. Those results are also competitive compared with active muni funds: Its since-inception annualized return has topped nearly two thirds of actively managed muni funds in the open-end muni national intermediate category.

In addition to tracking the same index and offering lower fees than their open-end rivals, both MUB and VTEB take a similar approach to the creation/redemption process. Specifically, both funds note that they have the flexibility to facilitate in-kind or cash creations and redemptions (or some hybrid of the two). With in-kind transactions, outside parties, or authorized participants, do the buying and selling of securities for ETFs, paying all of the associated fees and shielding existing investors in these ETFs from these costs--which are ultimately borne by investors buying and selling these funds' shares. With cash transactions, the ETF sources the bonds and pays the associated costs, much like an open-end mutual fund does when it gets an inflow of cash. Internalizing these costs (commissions, spreads, market impact, and so on) by virtue of facilitating cash creations and redemptions can weigh on a fund's returns. As such, both teams have expressed a preference for in-kind transactions.

While the Vanguard and iShares funds are broadly similar, there are some initial differences to note. First, MUB is much larger, with more than $6.2 billion in assets versus VTEB's roughly $250 million (as of March 11, 2016). In the realm of ETFs, size tends to beget liquidity, as measured by trading volume in an ETF's shares. Indeed, the iShares ETF is far more liquid than the Vanguard ETF at this point. Also, as mentioned previously, size lends itself to broader sampling and thus (in theory) more-efficient tracking. However, it should be noted that VTEB has shown very modest tracking error to date despite its much smaller asset base.

Another key difference between the two funds pertains to their structure. Like other Vanguard ETFs, VTEB is a share class of a mutual fund rather than a stand-alone ETF like MUB. Vanguard's structure has potential advantages and disadvantages. Investors in the ETF share class could benefit from the additional assets in the mutual fund if the added scale results in a lower expense ratio and better diversification. A potential disadvantage is that the tax consequences of trading activity in the mutual fund could have an impact on investors in the ETF share class. Although these factors differentiate the funds, the impact of each could be rather modest. If investors aren't expecting to trade the ETF frequently, then liquidity is less of a concern. Similarly, as we've noted in previous research,(3) the risk of spillover taxes is real but likely overblown. On a dollar-weighted basis, passive fund owners in either the mutual fund or ETF structure are being tax-efficient. That said, in a low-yield environment, even a modest 12-basis-point distinction in fees can have a meaningful impact on performance. Fees matter, and, in this case, Vanguard has the advantage.

The diverse and sometimes less-liquid nature of the municipal market poses challenges to investors looking for passive exposure. Funds such as the newly launched Vanguard Tax-Exempt Bond Index fund and MUB mitigate many of the perceived challenges of this market by sticking to larger, higher-quality, and more-liquid muni bonds. Those looking for exposure to the broad-based high-quality muni market would be well-served by considering these options. Reasonably priced, actively managed funds are a good option for investors looking for specific interest-rate risk or more credit risk.

1 Municipal Securities Rulemaking Board Fact Book 2014. http://www.msrb.org/msrb1/pdfs/MSRB-Fact-Book-2014.pdf

2 U.S. Municipal Securities Holders, quarterly data to 2Q 2015. http://www.sifma.org/research/statistics.aspx

3 Justice, P., & Lee, S. 2012. "ETFs Under the Microscope: Tax Efficiency Survey." (Chicago: Morningstar Research) http://corporate.morningstar.com/US/PR/TaxEfficiencyPaper.pdf

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