Market volatility supercharged the growth of municipal-bond exchange-traded funds in 2022 at the expense of open-end mutual funds, which may lose some of those assets for good.
Despite the worst market rout in 40 years, investors plowed a record $27.8 billion into municipal-bond ETFs this year, a striking contrast to open-end funds, which lost more than $130 billion. As much as half the inflows came from mutual fund holders selling shares at a loss to offset gains and swap into ETFs, according to estimates by Drew Pettit, director of ETF analysis and strategy at Citigroup Inc.
Municipal bond investors, who had been reluctant to move out of mutual funds during the bull market because of capital gains, have seen muni market losses of 8% this year, as the Federal Reserve hiked interest rates at the fastest pace in decades. The historically poor returns, however, provided tax-conscious municipal-bond investors the opportunity to harvest losses.
Lower trading costs and the growing adoption of model portfolios by investment advisors means a lot of the assets gained by muni ETFs will stay, Pettit said. This year’s inflows to muni ETFs are double the average of the last three years, bringing overall holdings to $105 billion.
Tax-loss harvesting “was a key catalyst that is helping drive asset flows and volumes,” said Pettit. “Once people buy into a product, it tends to be a little bit stickier in their portfolio, especially if they had a good experience transacting.”
Sharply Higher
Under tax rules, to offset gains, investors have to swap into a similar, but not substantially identical security, for 30 days. The biggest ETFs benefited the most.
The Vanguard Group Inc.’s Tax-Exempt Bond Index ETF raked in $10.9 billion, while BlackRock Inc.’s iShares National Muni Bond ETF attracted about $9 billion, or 70% of the category’s growth.
Citigroup estimated the impact of tax-loss harvesting on ETFs by matching muni mutual fund outflows over trailing weekly periods with inflows to ETFs and comparing flow trends in the prior two years.
These inflows were sharply higher, even in this year’s bear market, than the trend of slow and steady gains over the prior two years. Citigroup estimated that 25% to 50% of inflows into municipal-bond ETFs came from mutual fund counterparts.
Muni ETFs are also reaping the benefits from investors’ focus on all fees, not just management expenses, Pettit said.
Trading Costs
Trading costs for muni ETFs with more than $200 million in assets, are just 0.11%, slightly lower than bid-ask spreads for institutional-size cash bond trades, Citigroup found. Spreads for odd-lots blocks of $10,000 to $25,000 range from about 0.28% to 0.55%, according to the bank.
“When I buy an ETF I may actually be able to face off with someone on an equity exchange that is selling that day and that spread is very tight,” Pettit said.