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Can You Index Municipal Bonds?

Portfolio managers have stepped up their game.

Indexing has limitations. Some markets or market segments are easier to index than others. The degree of difficulty is largely a factor of the breadth, depth, standardization, and liquidity of the pool of assets in question. Nonstandard assets that are difficult to trade, like municipal bonds, can be difficult to index. Indeed, running an index-tracking municipal bond fund is a tricky proposition. The managers of an indexed municipal bond portfolio have to strike a balance between tracking their index and the costs involved in doing so. Based on the performance records of many of the municipal bond index funds available to investors, these funds’ managers appear to be capable of managing this balancing act.

Let’s say you’re a portfolio manager running a bond index fund. When your fund’s target index rebalances, you’ll likely need to do some trading so the fund’s holdings match those in the index. This is a necessary maintenance activity that keeps your fund’s portfolio and performance in line with its benchmark.

Now suppose the target index requires that you buy bond A following a rebalance. You go to the market, but there is only one willing seller of bond A. You make an offer to buy. But that lone seller knows he’s the only show in town and attempts to take advantage of his status by counter-offering at a higher price. You’re in a predicament. You can buy the bond, but it’s going to cost you. And that cost is absorbed by the fund’s shareholders.

The negotiation that occurs between you and the potential seller is a hypothetical example of the real difficulties of transacting in an illiquid market. In this hypothetical, you cannot buy the bond without affecting its price. Liquidity typically isn’t a big concern for most index-tracking funds. Many stock and investment-grade bond indexes intentionally track pools of liquid assets. In other cases, indexes are designed to capture the most liquid segment of less-liquid asset classes to keep their trading costs in check. The benchmark underpinning high-yield bond exchange-traded funds like iShares iBoxx $ High Yield Corporate Bond ETF HYG is an example of such liquidity-aware adjustments.

But there are some asset classes where the underlying market is relatively less liquid. Therefore, using an index strategy can result in higher tracking error and add to the fund’s costs. Municipal bonds have historically been one of these less-liquid assets.

Navigating the Muni Bond Market As in the previous example, the municipal bond market can be more expensive to trade in because it is less competitive than other fixed-income markets. Part of the reason is the market is much more fragmented than those for Treasuries or investment-grade corporate bonds. It spans tens of thousands of issuers and even more individual bonds. Many municipal bonds also have small face values. Thus, municipal bond pools tend to be narrow, shallow, and illiquid.

Given that many municipal bonds can be costly to trade, it isn’t practical to hold every bond in the index as a way to reproduce index performance. But portfolio managers have a clever solution. Rather than fully replicate the index’s holdings, they instead buy a sample of bonds from the index that, in aggregate, replicate important index characteristics like yield, duration, and credit quality. This allows them to reproduce index performance with bonds that are relatively cheaper to trade while avoiding those that are more expensive.

Sampling an index in this way isn’t anything new. Stock index funds have successfully used this strategy to deliver index performance without the need to trade illiquid areas of their market, like micro-cap companies. Done well, sampling is a reasonable approach.

But there are some important differences to note between stocks and municipal bonds. A successful sampling process requires both an understanding of the risk factors that drive index behavior and the ability to accurately price the underlying stocks or bonds. This type of information has historically been difficult to pull together for municipal bonds because the universe is so varied and the bonds don’t trade on an exchange like stocks.

Those have been some of the hurdles that portfolio managers had to overcome when indexing municipal bonds and executing a sampling strategy. But times have changed. Large asset managers like Vanguard, BlackRock, and State Street have refined their knowledge and processes over the past several years to enable effective index-tracking.

One of these improvements entails understanding what bonds will be added or removed from an index. This knowledge enables portfolio managers to add or delete bonds from a fund before the index recognizes the change during a rebalance. Furthermore, they can use this freedom to purchase bonds at auction rather than in the secondary market--a more cost-effective way to acquire new issues.

Another development over the past decade has been the Electronic Municipal Market Access website maintained by the Municipal Securities Rulemaking Board. It provides access to thousands of offering documents and bond prices that were previously difficult to obtain. In short, access to information and prices has improved significantly over the past decade, which has further bolstered muni index portfolio managers’ ability to track their bogies in a cost-effective manner.

The Result How well have index-tracking municipal bond funds delivered on their objective of high-fidelity tracking performance? The data in Table 1 show that municipal ETFs have generally done a good job of hewing close to their benchmarks. Vanguard Tax-Exempt Bond ETF VTEB and iShares National Muni Bond ETF MUB both track the S&P National AMT-Free Municipal Bond Index and had outstanding tracking performance--as evident in their low tracking error--over the three years through January 2019.

Morningstar has assigned Analyst Ratings to two more broad index-tracking municipal bond funds. Tracking error from SPDR Nuveen Bloomberg Barclays Municipal Bond ETF TFI and Invesco National AMT-Free Municipal Bond ETF PZA has not looked as good as MUB or VTEB. Both are cheap relative to their respective categories, but have been awarded Morningstar Analyst Ratings of Bronze, largely because their expense ratios aren’t competitive with low-cost alternatives.

To answer the question in the title, yes, despite the trading difficulties, municipal bonds can be indexed effectively. The well-managed funds highlighted in Table 1 are a few low-cost ways to access different segments of the municipal bond market or the broader market entirely. But it’s worth keeping an eye on their tracking error to ensure they’re still living up to their billing.

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