Indexing Comes to Muni-Ville

In August 2017,

Vanguard Tax-Exempt Bond Index

VTEAX turned two years old. The fund remains the market’s only municipal open-end bond index mutual fund. Although still in its youth, the fund's assets had grown to $1.8 billion as of Sept. 30, 2017.

As one of the cheapest funds in the muni national intermediate Morningstar Category at a mere 9 basis points, this fund has fared well relative to peers. These ultralow fees, combined with its strong risk-adjusted returns and efficient tracking of its index since inception, earn it a Morningstar Analyst Rating of Silver.

The fund’s largest exchange-traded fund competitor,

iShares National Muni Bond ETF

MUB, has also grown rapidly, recording net inflows of nearly $1.3 billion in the past year. The fund grew to $9.0 billion at the end of September 2017. Although a bit more expensive than the Vanguard fund, fees are still pretty cheap at 25 basis points. We rate the fund Bronze.

Passive funds are still something of a novelty in the muni market, partly because muni indexing poses particular challenges. Broad-market fixed-income indexes contain thousands of bonds, making it impractical for a fund to own every bond in its investable universe. Instead, they use a sampling technique to build portfolios that best represent the characteristics of their benchmarks, and how well each does this is reflected in tracking error.

In addition, the muni-bond market is particularly diverse and fragmented, potentially making the sampling process more difficult than for taxable bonds. The $3.7 trillion muni market includes more than 1 million individual bonds outstanding offered by more than 50,000 unique entities, including many small and infrequent issuers. Moreover, trading volumes in the muni market are much lower than in the taxable space because many muni investors buy and hold to maturity.

The Vanguard and iShares index funds have largely mitigated these concerns by sticking to high-quality, more-liquid parts of the market. Both funds track 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-bond market in the United States. By design, this benchmark focuses on the muni market’s most-liquid issuers by setting minimum credit rating and lot size requirements. Also, as assets grow in both funds, each can own a larger number of securities in the index, which should allow the portfolio to more closely align with the index, thereby keeping tracking errors low.

Investors looking for broad-based, high-quality exposure to the national investment-grade muni market would be well-served in considering one of these muni index funds. As with other index-based strategies, the passive nature of the structure eliminates many concerns regarding manager risk and offers investors access to rock-bottom fees. For those investors looking to add to income and total return by taking on additional credit risk, a reasonably priced, actively managed fund may be a good option.

For example, Gold-rated

Fidelity Tax-Free Bond

FTABX is likely to outperform the index in healthy muni credit markets, and the broader investment universe provides opportunities for managers to add value through credit research. The fund’s expense ratio matches that of the iShares muni fund, so it is priced competitively. For investors who are comfortable with lower-rated fare and potentially more volatility in exchange for higher yields, a fund such as Gold-rated

T. Rowe Price Tax-Free High Yield

PRFHX is a strong option in the muni high-yield market.