After a record year for municipal exchange-traded funds in 2021, industry experts predict the growth will continue this year despite recent market volatility and some outflows to start 2022.
In 2021, ETFs grew to about $85 billion. ETFs, along with the larger muni mutual fund complex, saw pressure amid the onslaught of Fed interest-rate led volatility across markets beginning in January.
The Investment Company Institute reported two weeks of outflows from ETFs — $523 million the week ending Jan. 26 and $13 million the following week. Refinitiv Lipper’s most recent figures showed ETFs with $62.672 million of outflows for the week ending March 2, while muni mutual funds posted $2.8 billion of outflows.
CreditSights noted that ETFs pulled in just about $2 billion in February while muni mutual funds saw $8.5 billion of outflows.
Municipal ETF inflows indicate buyers are "not so much leaving the asset class as much as redefining the format by which they invest," said Kim Olsan, senior vice president at FHN Financial. "Among leading ETF sponsors, generic returns mirror that of benchmark indices so far this year (all down 3% or more)."
Volatility may explain some of the outflows. “There were [ETF] outflows that you might characterize as ‘short-term horizons,’ looking to go elsewhere until the market settled into a more understandable or normalized trading pattern,” said Jim Colby, portfolio manager with VanEck, a global investment manager with 63 ETFs that have total assets under management of $63.5 billion. “I think that's exactly what's happening right now.”
On Wednesday, ICI reported $556 million of inflows in the week ending Feb. 23 after inflows of $627 million the week prior, and Refinitiv Lipper’s most recent figures showed ETFs with $62.672 million of outflows for the week ending March 2 after $288.247 million of inflows in the previous week.
Patrick Luby, senior municipal strategist at CreditSights, said it’s too early to say whether overall ETF projections for 2022 will be impacted due to recent market volatility, believing it would be premature to extrapolate the whole year based on what has happened over the past few weeks.
He does believe 2022 will still see ETF growth, though.
“Muni ETF assets will continue to grow — at least within the muni ETFs because the flows are being redirected into different strategies,” he said. “That suggests that net investors are maintaining their exposure to munis; they're just changing the duration exposure of their muni and mutual fund flows.”
Historically during periods of high volatility or rising yields some mutual fund investors appeared to exit munis by just reducing their muni mutual fund exposure overall rather than shifting within muni mutual funds, according to Luby.
“In periods of volatility or rising rates or political issues, domestically or internationally, ETFs offer an opportunity for investors to move their assets around to a position of relative safety and lower volatility,” Colby said. “And you can find that in the muni market, certainly. As an asset class, ETFs have the reputation of being a pretty sound secure investment in terms of credit quality. So I think that's part of what's going on right now.”
Over the past few years, muni ETFs have captured anywhere from 20% to 25% of inflows, which Colby said is significant enough to suggest that growth will continue. VanEck last fall launched the
“There’s momentum. ETFs reasonably will continue to have a prominent role in asset allocation and strategy going forward. So look forward to a decent year for 2022,” Colby said.
Moreover, institutional investors and ETFs are progressively displacing conventional mom-and-pop investors in the nearly $4 trillion muni market. This is a tendency that has contributed to the asset class's changing behavior and composition, said Eric Kazatsky of Bloomberg Intelligence.
Individuals have boosted their investment in municipal-focused ETFs, in part due to fees, with the top ETF providers charging on average seven basis points, according to Kazatsky. The appeal of passive ETFs is evident, as they charge around half the costs of active bond funds, which carry close to 37 basis points in asset-weighted expenses.
According to tax-exempt ETFs, which have acquired $21 billion in assets over the last year, muni investors are still looking for low-cost exposure. Kazatsky said these fees climbed by 3 to 17 basis points in 2021, compared to previous periods when the asset-weighted industry average cost decreased, partly attributable to the greater cost of new entrants into the market.
But with the influx of ETFs and mutual funds buying up a larger chunk of munis, Luby said it’s concentrating demand into a smaller number of objectives or strategies.
Several decades ago, most of the demand in the municipals was from millions of individual investors buying individual bonds.
This is no longer the case, as there are now a much small number of “investor types” pursuing bonds. Many of these investors are trying to buy new issues and sell their older seasoned bonds into the secondary market.
“They're all kind of buying and selling around the same point in the yield curve, and so that tends to direct all the buying and selling to the same part of the market, adding to the challenge of finding liquidity in the market,” Luby said.
“If you're trying to sell what everybody else is trying to sell, and the market is getting weak, that can add to the volatility because there's not enough diversity of demand,” he continued.
However, Luby was quick to add it’s not so much a negative consequence of ETFs but a result of the concentration of demand.
“But when the market becomes volatile, it's easier for opportunistic buyers to step in. A speculative buyer could step in immediately and buy ETFs pretty quickly and easily to take advantage of that,” he said. “That helps everybody because then you have incremental buyers coming into the market.”
ETFs are preferred by institutional investors for several reasons. For one, ETFs make it simpler to buy and sell large portfolios instantly instead of trading individual securities, Luby said.
When investors sell ETFs, Luby said, bonds don't have to change hands because the shares are trading at the exchange. So there can be normal day-to-day selling going on in the ETFs, where investors are reducing their exposure, and that may pressure prices down, he said.
But the ETFs themselves are trading; that adds to the liquidity of the ETFs, which supports the liquidity of the underlying bonds.
Another draw is the accessibility, making it easy for different types of investors to participate in the market, Luby said.
“So if a [registered investment advisor], for example, opened up a shop, and as long as they have a custodial agreement, they can get access to the entire universe of ETFs,” he said. “Because they're easy to transact and select, the participants tend to be broader as well.”
And as investors head into a potentially volatile and uncertain year, Colby said the ETF structure being transparent gives investors comfort.
While mutual funds are dominated by individual investors, Luby said ETFs are more widely used and not just limited to retail; it’s also advisors, institutional investors, insurance companies and large separately managed accounts that use ETFs as a part of their portfolio.
For the investor who's concerned about a rising-rate environment, and maintaining exposure communities, ETFs allow them to take a duration target that makes sense for them.
Third is efficiency. ETFs can be traded quickly and typically have lower transaction costs relative to the underlying basket of securities.
During heightened market volatility ETFs were much more cost-efficient than the underlying basket — especially in the case of high-yield bonds, Colby said.
Even if the Fed raises interest rates four times in 2022, Colby said, the market will still be at rate and cost levels that will show the advantage of an ETF, particularly for those who aren't interested in highly diversified structure, which most muni ETFs are.
“Being able to see the valuation moment by moment, minute by minute, and having the ability to buy a share of an identified product, whether it's investment-grade or state-specific or high-yield, gives you the ability to allocate as little money as the cost of one share or as much as institutions can put up to grab a significant position for their portfolio,” Colby said.
Luby said ETFs can be used to adjust the portfolio, so for
The opposite can be done as well.
“I think we'll see more investors using ETFs for tactical exposure. I think we'll continue to see some of the institutional investors using ETFs as a supplement for portfolio and individual bonds,” Luby said.
Liquidity remains one of the biggest sources of concern among investors and one of the greatest sources of risk in the muni market. And because ETFs are exchange-traded, it provides access to a different type of liquidity, according to Colby.
The larger market has accepted ETFs as a significant entity, along with being another source of liquidity, Colby said.
Therefore, it's one of the very few ways that investors have of diversifying their liquidity risk in a portfolio.
“It makes a lot of sense to have — especially for a large portfolio — to have a portion of the portfolio dedicated to highly liquid investments. And ETFs can be one of those investments,” Luby said.
