Thanks to a hefty amount of tax uncertainty, historically high yields and overall strong fiscal health, municipal bonds have continued to be a top draw for many investors across different tax brackets. Fund flows into muni ETFs have continued to rise, and more recently, the number of active ETF offerings in the space has jumped. More than half of all the active ETFs in the space have launched within the last two years.
And it turns out, that might be a great thing for investors.
According to asset manager AllianceBernstein, being active in the muni sector is better than simply following an index. Historically, outperformance has been on the active investor’s side. And there are three reasons why.
A Surge in Investor Interest
Bonds by nature are generally pretty boring. And municipal bonds are perhaps the most boring of them all. Issued by state/local governments and featuring tax-advantage/tax-free income potential, the conservative nature of these bonds attracts conservative investors, pension funds, and insurance firms. We’re talking about a very “buy & hold” investor base.
Which is why it’s wild that so many investors have started to hone in on munis over the last couple of years.
Driven by future tax uncertainty and yields reaching historical highs, investors have gone crazy for muni bonds. Naturally, Wall Street has launched new products. According to Morningstar data, 15 new muni-bond ETFs were listed on exchanges last year. This follows the 12 that were listed in 2023. So far this year, we’ve already had several more launches.
What’s even crazier? They have been active ETFs. So much so, that the number of active muni ETFs has surpassed the number of passive products by a wide margin.
Moreover, with many asset managers looking to exploit Vanguard’s expired ETF share-class patent, the number of active ETFs is expected to surge even further, and they could overtake mutual funds in the future as the investment structure of choice for all investors.
Active Wins Out
For investors, the surge in active muni bond ETFs is a big win. It turns out that active managers within the sector can deliver additional alphas. Looking at rolling three-year returns, AllianceBernstein found that 98% of active muni strategies have meaningfully outperformed passive approaches. Looking at two-year rolling returns, 89% of active managers have managed to beat their muni benchmarks. 1
According to AllianceBernstein, there are three significant reasons why active beats passive in the municipal bond space.
For starters, active managers can use the yield curve to their advantage. Different maturities along the municipal yield curve are constantly shifting in response to changes in economic conditions. For passive index investors, they are stuck with the yield curve and how it plays out with regard to their mandates.
However, active managers can selectively choose different maturities along the curve to play a variety of current and future yield-curve scenarios. AllianceBernstein cites that this could be a “barbell approach” — owning long and short bonds or more concentrated positions. The point is that managers aren’t and don’t have to be static with their holdings.
Aside from different maturities, active managers can also play along the credit risk profiles of muni bonds. Many passive index funds and benchmarks within the sector leave out a wide variety of municipal bonds, particularly some top tier investment-grade bonds. Active managers can move slightly down the credit ladder to add additional yield, which tends to be the major driver of municipal bond returns.
The best part is that many high-yield munis bonds and IOUs within the muni credit universe are still top notch in terms of credit quality while offering significantly higher yields than highest-quality bonds. This chart from AllianceBernstein shows that high-yield munis offer more yield.
Source: AllianceBernstein
However, the reward of these “high-yield” munis greatly outweighs the slight additional risk. Many high-yield munis include riders and stopgaps, such as first liens on property or assets, and revenue pledges, and even tax pledges from the issuing state/local government that supports the bond’s repayment. The 10-year cumulative default rate for high-yield munis is only 3.97%. To put that in context, the default rate for high-yield corporate bonds is around 33% over the last decade.
The win is that active managers can play in this sandbox to boost yield over broad passive indexes that can’t or don’t include these bonds.
Finally, active managers can take advantage of dynamics to time their buys or sells. Muni bonds don’t exist in a vacuum. Many active managers look at after-tax yields on municipal bonds versus bread-and-butter Treasuries to help make informed decisions on buying or selling. When spreads between the two sectors have widened, it is a good chance to purchase munis to gain income and capital gains potential. When spreads narrow, muni managers can sell appreciated bonds or sit back and clip coupons for returns. This nimbleness allows many active mutual fund managers to beat their passive benchmarks, who are forced to constantly roll over their holdings to meet mandates.
Active ETFs for Active Muni Investment
With these three reasons in tow, investors may want to get active with their municipal bond holdings. The growth of ETFs in this avenue has been a boon in helping deliver on this fact. There are now numerous funds across various muni sub-sectors that can be used to target active management within the tax-free bond space.
As with any active manager, digging into the fund’s underlying holdings and strategy is key. The way to win could be to buy two or more active ETFs to diversify away from manager risk. Luckily, the ability to buy fractional shares, their quick tradability, and the low-cost nature of ETFs make this an easy proposition. Additionally, splitting their muni holdings into a passive and active fund could pay serious benefits and provide enough outperformance.
Active Municipal Bond ETFs
These ETFs were selected based on their ability to provide low-cost and active exposure to the municipal bond market. They are sorted by their YTD total return, which ranges from 0.5% to 1.8%. They have expense ratios between 0.12% and 0.65% and assets under management of $127M to $2.6B. They are currently yielding between 2.5% and 4.4%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| SHYM | iShares High Yield Muni Income Active ETF | $295M | 1.8% | 4.4% | 0.46% | ETF | Yes |
| IMNU | iShares Intermediate Muni Income Active ETF | 244M | 1.5% | 3.6% | 0.41% | ETF | Yes |
| MUNI | PIMCO Intermediate Municipal Bond Active ETF | $1.75B | 1.4% | 3.2% | 0.35% | ETF | Yes |
| CGMU | Capital Group Municipal Income ETF | $2.59B | 1.4% | 3.4% | 0.27% | ETF | Yes |
| SMMU | PIMCO Short Term Municipal Bond Active ETF | $630M | 1.2% | 2.9% | 0.35% | ETF | Yes |
| MEAR | iShares Short Maturity Municipal Bond Active ETF | $733M | 1% | 3.1% | 0.25% | ETF | Yes |
| VCRM | Vanguard Core Tax-Exempt Bond ETF | $127M | 0.9% | 3% | 0.12% | ETF | Yes |
| FMB | First Trust Managed Municipal ETF | $2.04B | 0.8% | 3.3% | 0.65% | ETF | Yes |
| DFNM | Dimensional National Municipal Bond ETF | $1.42B | 0.8% | 2.5% | 0.19% | ETF | Yes |
| TAXF | American Century Diversified Municipal Bond ETF | $508M | 0.5% | 3.6% | 0.29% | ETF | Yes |
All in all, active management can be a big win for many sectors. This is particularly true about municipal bonds. AllianceBernstein’s research shows that the ability to move up and down the yield curve, the ability for managers to take on different credit risk, and managers’ ability to time their purchases/sells are the main reasons so many active muni managers beat their passive benchmarks. The growth of active ETFs in the sector can only be seen as a big win.
Bottom Line
Active municipal bond management is a proven winner for portfolios, offering greater returns and index outperformance. Thanks to the ability to change credit and yield-curve positioning as well as timing their buys, AllianceBernstein’s research shows that active is the way to go within the sector.
1 AB.com (February 2025). Three Reasons Why It Pays to Be Active as a Muni Investor
