(Bloomberg) -- 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 swapping 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 advisers 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 ETF’s are also reaping the benefits from investor 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%, sightly 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.
Rules that took affect in 2018 requiring brokers to disclose to their customers how much they’re charging for municipal-bond trades has brought greater scrutiny by investment advisers to trading costs, he said.
Continued adoption of model portfolios by investment advisers and their clients will also contribute to muni ETF growth, according to Citigroup. Model portfolios, purchased from investment platforms, package ETFs and other funds into customized strategies that can be tweaked based on risk appetite and market moves.
Model portfolio mangers like FMR LLC’s Strategic Advisers, Wealthfornt Advisors and Creative Planning, are among the biggest holders of Vanguard’s and BlackRock’s muni ETFs, according to securities filings.
Advisers like the automated, off-the shelf products which allow them to focus more on client relationships even as they grow their business, Pettit said.
“When model portfolios get their teeth into an ETF or a group of ETF’s, you start to see this stable, almost constant, drip of money coming into these products,” Pettit said in an interview. “And it’s really hard to unseat that.”