Municipal exchange-traded funds, still a relatively new and small part of the $4 trillion state and local debt market, have seen growth stall dramatically after record inflows last year as the shift away from mutual funds slowed.
These ETFs have garnered about $3.9 billion so far this year, down from $14.8 billion in the year-ago period, according to data compiled by CreditSights. This marks a slowdown from last year, when a record $29 billion flowed into the funds, which had attracted investors with lower fees and the opportunity to tamp losses in the worst muni-market rout in decades.
Since they were first introduced into the muni market about 15 years ago, assets in such ETFs have surged to roughly $110 billion, according to data compiled by Bloomberg. Morgan Stanley expects muni ETF assets to jump to $200 billion by 2026, one-third of the time it took to reach the $100 billion mark.
Even though these funds are still a small part of the muni market, they have grown rapidly and provide investors with less capital an entry point. That growth was hindered this year, largely because of outflows in short-duration ETFs as individual investors opted for Treasuries and actively managed funds to weather the volatility in markets, said Bloomberg Intelligence’s Eric Kazatsky.
“This year’s slower pace in ETF flows were due, in large measure, to the expectations of Federal Reserve’s rate hikes and the expectation of higher muni yields,” Patrick Luby, a senior municipal strategist for CreditSights, said in an email. “With the market now pricing that the terminal rate is not far off, I expect that we will see increased comfort with and demand for duration, and that ETF flows in the second half of the year will be stronger than in the first half.”
Muni investors closely track the Fed and follow signals from the Treasury market. On Wednesday, the Fed raised borrowing costs for the eleventh time since March 2022 to bring down inflation. The quarter percentage-point increase boosted the target range for the Fed’s benchmark federal funds rate to 5.25% to 5.5%, the highest level in 22 years.
‘A Pause’
Paul Malloy, Vanguard’s head of municipals, said he’s optimistic that muni ETFs will endure and expand. Vanguard operates one of the two largest muni ETFs and saw positive inflows this year.
“I would not say it’s a steep drop. I would say it’s a pause,” Malloy said in an interview about the broader muni ETF market. “Over the next five years, we will see a meaningful increase in the market share of muni ETFs.”
He expects growth in the broader category as well because it offers a lower-cost option and access to a diverse cross-section of tax-exempt muni assets. Additionally, muni ETFs add liquidity into the market, he said.
Last year, muni ETFs benefited from investors seeking a way to harvest losses without losing their exposure to munis. The process involves the sale of assets at a loss, after which investors must buy a similar but not identical security for 30 days to curb taxes and capital gains.
So, investors rushed to ETFs while yanking more than $100 billion from mutual funds focused on state and local debt, contributing to an 8% loss the muni market saw last year. Citigroup estimates that between 25% to 50% of inflows into muni ETFs were likely from muni mutual funds as investors sought to monetize their paper losses, said Drew Pettit, director of ETF analysis and strategy at the firm.
“We are still bullish,” Pettit said, despite this year’s muted inflows. “The flows are just a normalization of long-term trends. It’s not a shift lower.”
--With assistance from Amanda Albright.
This article was provided by Bloomberg News.