Muni ETFs give some advisers pause

Although financial advisers generally welcome new exchange traded funds that invest in municipal bonds, some industry experts question whether they are the best way to access such an opaque market. Two muni ETFs were launched this month, bringing the total number to 16. They are the Market Vectors High-Yield Municipal Index ETF (HYD) and the Market Vectors Pre-Refunded Municipal Index ETF (PRB), from Van Eck Associates Corp. of New York.

BOTH EXTREMES

They represent the first ETFs to invest in an underlying index of junk and pre-refunded muni bonds, respectively, segments of the muni market that are at opposite ends of the risk spectrum. High-yield muni bonds are rated BB or below. Pre-refunded muni bonds are among the highest-quality bonds of this type because the income and principal are normally secured by an irrevocable trust of Treasury securities. "With these ETFs, we have now captured virtually all elements of the municipal market," said Jim Colby, a senior municipal strategist and portfolio manager with Van Eck. Van Eck also offers muni ETFs that invest in short, intermediate and long muni bonds. Barclays Global Investors of San Francisco, Invesco PowerShares Capital Management LLC of Wheaton, Ill., and State Street Global Advisers of Boston also offer muni ETFs. No such ETFs existed until Barclays launched the iShares S&P National Municipal Bond Fund (MUB) on Sept. 7, 2007. Some are hesitant, however. "I'd like to see how they perform before I work them into a taxable portfolio," said Richard Romey, president of ETF Portfolio Solutions Inc., an Overland Park, Kan.-based advisory firm with $40 million in assets. His caution is understandable. When the credit markets froze in September, bond ETFs — particularly those that invest in muni bonds — ended up trading at an unusually wide discount to their net asset value. That isn't supposed to happen with ETFs. But few investors were buying bonds, meaning that it was hard to get reliable prices, said Scott Burns, director of ETF analysis at Morningstar Inc. of Chicago and editor of the Morningstar ETF Investor newsletter. It was an unusual situation and doesn't necessarily reflect badly on the ETFs, he said. "It's not a good thing that it happened, but the reality is, they still traded," Mr. Burns said. And that is a big plus during a time when an investor who may have bought individual bonds would have been in a position where it would have been impossible to sell those bonds, he said. The situation in the muni markets has improved, and muni ETF discounts have narrowed. Given those circumstances, muni ETFs may appear more attractive to investors. Several industry experts have said recently that the best bond values are to be found in the muni markets. Muni bond prices were depressed not because of problems with the bonds themselves but because deleveraging forced many hedge funds to flood the market with muni bonds, they argued. That and problems faced by muni bond insurers related to the subprime-mortgage crisis forced muni prices down. But that doesn't mean that investors should run to buy muni ETFs. Actively managed mutual funds may be the better option, said Jim Lowell, Needham, Mass.-based editor of Forbes ETF Advisor, a monthly newsletter. Active managers can add value because the muni market is opaque and often illiquid, he said. Particularly in this volatile market, a manager who is good at selecting bonds can add value, Mr. Burns said. The trick is finding such a manager, said Tom Lydon, president of Global Trends Investments, a Newport Beach, Calif.-based firm that manages $75 million in assets. For investors who don't want to take the chance that they have chosen the wrong manager, a muni ETF makes perfect sense, he said. E-mail David Hoffman at dhoffman@investmentnews.com.