Muni Funds: CEFs vs. ETFs in 2009

Despite the stock market’s inauspicious 2009 start (the S&P 500 off 5.9% YTD), closed end funds (CEFs) on average are up 8.5% YTD. This divergence may be attributable to the fact that 60% of CEFs are considered fixed income investments. Such investments typically do better in down markets. Of the fixed income fund types, CEF state and national muni funds generated the strongest YTD share price performance, up 14.9% and 14.3%, respectively. The positive return of the muni bond sector was also reflected in the six muni ETFs; up on average a more modest 2.7%. The end table compares the largest muni CEFs with the largest muni ETFs. Muni ETFs seem a better choice for longer-term investors. Muni CEFs provide investors with a leveraged speculative trade.

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Muni Fund Type Performance: With 41 out of 50 states projecting budget shortfalls in 2009 and a few facing the prospects of bankruptcy, the strong performance of muni CEFs seems curious. Such performance could be a function of one or a combination of the following factors:

1. a general belief the credit markets are improving and it’s OK to get back in the fixed income markets;

2. a belief there will be some type of federal rescue package that would support the muni bond markets;

3. compelling investment characteristics: historic spreads to treasuries and discounts to NAV;

4. a “dead cat bounce” from year-end tax selling.

Investing or Speculating? Currently, when it comes to investing in CEF muni funds (of which 92% employ leverage), investors should recognize they have left the realm of investing (assessing quantifiable risk) to one of speculation (predicting event uncertainty). While we have come a long way in stabilizing the financial infrastructure, there are still economic uncertainties close to the surface. (IMHO, the federal government is likely to step in and provide some support for the muni bond markets. A collapse in municipal financing would be a congressional politician’s nightmare, where you rescue NYC bank executives and not municipal workers. Having said that, 50% of all accidents occur in the home, the other 50% occur in Congress.)

Muni CEFs vs. Muni ETFs: An alternative to investing in muni CEFs is muni ETFs. Muni ETFs typically have lower management fees and employ little leverage. Some of the muni ETFs of which I’m aware are: PZA, ITM, MUB, TFI, PVI and SHM.

The following table compares two of the largest muni CEFs (green) without ARPS, with two of the largest muni ETFs (blue). Both NUV (CEF) and MUB (ETF) employ no leverage. The ETF (MUB) may be a better choice in this category as the yields are comparable and it has a lower premium and management fee.

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EIM’s (CEF), advantage over TFI (ETF) in the leverage category is its material higher yield, although its management fee is 7 times that of the ETF. (Note: TFI currently does not show to be using leverage.)

It would appear from a cursory review, ETFs maybe a better choice in both the unleveraged and leveraged categories for a conservative way to invest longer-term in the muni funds market.

For more aggressive investors looking to speculate in the muni funds area, leveraged national muni CEFs with the greatest discounts YTD are: MNP, XAA, DTF and PIF. Remember, leveraged CEFs are subject to regulatory leverage ratios which may prevent them from temporarily making distributions while in violation.

Comments

[Scott F:]

ETFs cannot use leverage in the manner of CEFs, so all muni ETFs are unleveraged. Picking CEF munis purely on current discount is a risky game. Many are at deep discounts for good reason: junky portfolios, bad management, excessive fees. Far better to find historically wide discounts in lower cost CEF munis with low call ratios and decent ratings. That all being said, credit ratings are near worthless and so are the rating companies. Proceed cautiously.

Jan 20 12:44 PM

[Joe Eqcome:]

Scott F., let’s parse your comments:

“ETFs cannot use leverage…” ETFs can employ leverage in multiple fashions: 1) there is a significant segment of ETF population that employs leverage; they are known as “Ultras”, “Doubles”, “2x” and the like. The fact they may employ options or derivative strategies to create leverage doesn’t negate their intent. Secondly, ETFs can employ leverage with debt. SPDR Lehman Muni (TFI), an ETF, in its prospectus, if you care to read it, states, that the fund can lend its securities to other financial intermediaries. I quote, “These loans cannot exceed 33 1/3% of each Fund’s total assets.” So, ETFs can make loans and buy additional securities with the proceeds. (However, if you still feel strongly about your position, you should contact Thomson Reuters’ data services and inform them they are in error with regards to its classification of TFI as a “leveraged” ETF. I’m sure they’ll take your suggestion under advisement.)

“Picking CEF munis purely on current discount is a risky game.” This is particularly true if you’re not an astute investor. Most investors understand risk is typically priced into a securities valuation. In times of panic, the prices of securities exceed that of the implied risk, i.e., stock price is lower than intrinsic value. My effort in pointing out such CEFs is based on the historical inverse relationship between a CEF’s relative discount and it subsequent price appreciation. It is noted for the purpose of further exploration by investors and not as recommendations. As always, investors should understand their risk tolerance and never invest with scared money.

“Far better to find historically wide discounts in lower cost CEF munis with low call ratios and decent ratings…” I, and I believe many others, would welcome your detailed analysis with supporting data regarding your contention. Particularly, we’d like to see you compare your strategy with the one of picking deep discount CEFs.

“Proof by assertion” only works for college professors. It’s of little value in the world of investing.

Happy trails!
Joe Eqcome



On Jan 20 12:44 PM Scott F wrote:

> ETFs cannot use leverage in the manner of CEFs, so all muni ETFs
> are unleveraged. Picking CEF munis purely on current discount is
> a risky game. Many are at deep discounts for good reason: junky portfolios,
> bad management, excessive fees. Far better to find historically wide
> discounts in lower cost CEF munis with low call ratios and decent
> ratings. That all being said, credit ratings are near worthless and
> so are the rating companies. Proceed cautiously.

Jan 21 01:19 PM

[HighTower:]

I agree with Joe. I'd like to see Scott provide some support for his comments. He may be correct, but until he can document it, its just vague conjecture.

Jan 21 02:18 PM

[jwalker99:]

Hi Joe

thks for the comments. Good stuff.

Nov 13 07:59 PM