Bonds

As the landscape of retail changes, investors are looking to exchange-traded funds and separately managed accounts as alternate investment strategies, both of which have seen tremendous growth over the past decade.

Since the launch of the first muni ETFs in 2007, ETFs have grown in popularity, similar to how mutual funds grew their products in the ’80s and ’90s, said Jim Colby, portfolio manager with VanEck.

“ETFs have gained a foothold because, in many ways, it’s a way to replace the nature of mutual funds and individual funds with something that added an unusual aspect to it,” he said. “And then the unusual aspect is ‘We trade as a stock, we trade every day on several different exchanges.'”

ETFs are also cost-effective and help investors acquire a significant amount of diversification, all of which have contributed to meaningful growth, sources said. Over the past few years, more muni ETFs have come to the marketplace. VanEck in September 2021 introduced a sustainable muni bond ETF, and State Street Global Advisors launched an environmental, social and governance-focused ETF in April 2022. Months later in October, Schwab Assess Management launched a low-fee ETF, and in March, Goldman Sachs launched its first muni ETF.

This growth persists even in the face of market volatility and economic uncertainty.

Last year “was one of the worst ever for fixed income performance,” but ETFs were one of the bright spots with a record $27 billion of inflows into muni ETFs, or around 31% of total ETF assets, said Barclays strategists in a February report.

Additionally, the latest Fed data shows that ETFs were up in Q4 2022, increasing $20.7 billion to $104 billion, or 24.8%, year-over-year. This included $15.5 billion in net inflows for the quarter, said Pat Luby, a CreditSights strategist.

And while there have been recent outflows, Barclays strategists believe “ETFs will become a more dominant force in the muni asset class.”

Due to the market and economic uncertainty, bonds remain a predictable place for investors to safeguard their principal. But even with rising yields and widening spreads there is still an opportunity to put some money to work, Luby said.

“If you had to wait for the new-issue market, you might miss that opportunity,” he said. “So you can use ETFs to lock in exposure to munis until you find bonds that suit your suit your needs.”

“We’re in a market right now where there’s heightened volatility in prices, inconsistent pace of supply, and for investors who need to put money to work, muni ETFs continued to play that role,” Luby said. “There’s an increasing number of bond investors who are using ETFs as supplements to their portfolios.”

In 2022, the “growth in muni ETFs outpaced that of muni closed-end funds by a large margin: muni ETFs ended 2022 with over $100 billion in total AUM, compared with $80 billion for closed-end muni funds and $750 billion for open-end muni funds,” Barclays strategists said.

As “macro concerns dominating for much of 2022, and mutual funds posting record outflows, investors prioritized liquidity and ease of execution,” according to Barclays strategists. Therefore, investors “likely relied on muni ETFs for liquidity, which kept ETF volumes elevated,” they said.

Additionally, Barclays strategists said “some institutional investors, as well as SMA accounts, used ETFs as placeholders, especially during volatile periods, helping boost demand for the product.”

And given that “2022 was one of the worst total return periods on record for both the investment grade and high yield muni indices as well as funds benchmarked to these indices, mutual fund investors incurred losses on their muni holdings,” Barclays strategists said.

However, they noted “some investors likely utilized tax loss harvesting to sell their mutual fund shares and reinvest those proceeds into muni ETFs, helping boost inflows into ETFs (although we may be in the early stages of the reversal of this trend).”

Like ETFs, SMAs have seen growth over the past several years. Citi Research found SMAs have grown from $100 billion in 2008 to $779 billion in Q4 2021, while Cerulli Associates found muni SMAs have grown from $139.3 billion in Q4 2017 to $257.7 billion in Q3 2021.

Despite this evidence of growth, it’s hard to determine how much SMAs grew in 2022, if at all.

The latest Fed data shows that the household muni ownership — which includes SMAs, along with direct ownership of individual bonds in brokerage accounts and fee-based advisory accounts — was $1.6 trillion in 4Q 2022. This is down by $211.9 billion or 11.7% from the previous year.

Since the Fed does not break out muni ownership of SMAs, anecdotal evidence paints a better picture.

SMA portfolio managers continue to accumulate assets, Luby said, as investors and financial advisors continue to want to leverage full-time professional managers to oversee their portfolios.

The concept of SMAs was a “Back to the Future” type of scenario, according to Colby.

“Every trust department manager 40 to 50 years ago was managing SMAs before mutual funds began to emerge and attracted assets away.” Now, “we’re back to a platform, it seems where SMAs have grabbed in a significant prominence; they staked out greater territories than mutual funds did back in the ’80s and ’90s,” he said.

“That method of managing money, that sort of structure has become extraordinarily attractive, and, part of the menu that asset managers now have employed,” Colby noted.

Moreover, over the past decade, the muni industry has been transitioning to cater more heavily to very high net-worth clients, said Matt Fabian, a partner at Municipal Market Analytics.

“As tax-exempt munis have become more scarce and yields have gone down versus other instruments, the investor needs to buy more munis to produce the same [amount] of income that they had before,” he said.

SMAs are better fit for wealthy clients, “who can afford to buy twice as many munis than a less well-off client,” Fabian said.

The interest in SMAs is also “predicated upon the additional credit support and individual credit help, which stemmed from 2008, became a little bit stronger during the pandemic, and for the most part, that’s kind of lasted into the current period to,” according to Matthew Gastall, executive director and head of wealth management municipal research and strategy at Morgan Stanley.

The tailored nature of SMAs is also attractive, he said.

“When you own individual securities, you can tailor accounts,” Gastall said. “So that way, they basically function and do exactly what you want them to do, whether that’s from picking the credit qualities or final maturities, even trying to tailor when the coupons are paid, or when the income is actually coming in.”

Anecdotally, there has also been evidence of retail investors moving from mutual funds into SMAs as assets have been shifted out by individual investors into professionally managed SMAs, these accounts are then professionally managed per an investment policy statement, Luby said.

Additionally, he said the growth of SMAs has pushed the cost of accessing SMA strategies down.

“So they’re becoming much more affordable for individual investors,” Luby said. “So you don’t have the same embedded overhead and cost a mutual fund has.”

The customized nature of SMAs means it can be set up to look a lot like individual mutual funds, according to Fabian.

Mutual funds can tend to “chase momentum” more than SMAs, and some investors may prefer the defensive nature of SMAs, he said.

However, despite the advantages of ETFs and SMAs, there are still drawbacks.

ETFs, for instance, even though they are funded by bond products, they’re not bonds.

“But you generally don’t have a stated maturity dates when the monies are coming back [with ETFs], which means that you won’t have that period where the money comes back to you,” Gastall said.

SMAs, for the most part, are used by high-net-worth clients due to the high investment minimums.

“There’s a high barrier to entry,” Luby said. “So there are some laddered portfolio strategies that have $100,000 minimum, but to have a well-managed portfolio really need to have at least $250,000 or $500,000 in munis. That’s not practical for every investor, certainly for investors in the accumulation phase of their life.”

“What we’re going to continue to see is never a one-size-fits-all market,” Gastall said. “As time progresses, and the industry evolves, we’re going to continue to see both ETF and SMA growth.”

Colby sees the second half of 2023 into 2024 as a rebound and “a return of cash and funds to both of SMAs and to ETFs.” 

Luby also sees room for both ETFs and SMAs to grow. The economic and market challenges are in favor of active management, and ETFs and SMAs, in different ways, both provide “easy-to-understand ways for investors to get access.”

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