Muni ETFs: Less Pricing Risk Than Mutual Funds With Illiquid Assets

Includes: MUB, TFI
by: GridLex

Investors in muni ETFs may be scratching their heads in light of the recent beatings that they have taken, wondering how comparable mutual funds are relatively better off. The answer may not be in the superior investment skills of the mutual funds, but rather, could be because of stale pricing of the underlying illiquid bond holdings of the mutual funds that do not reflect market pricing.

Dan Seymour from the Bond Buyer (the leading publication on Municipal Finance) recently wrote about illiquidity in the muni bond marker, explaining how that impacts pricing on ETFs, and why ETFs move before indices.

A key excerpt from the article is given here:

“Muni ETFs definitely seem to be precursors reflecting expectations of the muni market, especially in the fourth quarter,” said Phil Fang, who manages the municipal ETFs at Invesco PowerShares. “We believe that muni ETFs can reflect the expectations of the muni market ahead of it.” In that sense, the more dramatic sell-off of municipal ETFs may have been presaging further weakness in municipal bonds, as well as manifesting weakness in the bond market that wasn’t showing up in indexes. The muni market includes more than 60,000 issuers and at least 1.2 million CUSIP numbers. Munis are considered less liquid than Treasury or corporate bonds. Some muni bonds never trade, and most trade infrequently. Indexes designed to reflect values in the municipal bond market rely on pricing services, such as Interactive Data, to evaluate bonds that aren’t trading. Investors don’t necessarily always believe these pricing services: it might be that a bond that would otherwise be trading at a lower price is quoted by a pricing service at a higher price simply because nobody is trading it, so there’s no discovery of the lower price.

So, if the benchmarks lag the general ETF market in coming to a market based pricing, could mutual funds also exhibit a similar lag in catching up to market based pricing? This question becomes all the more important when you look at the methodology of pricing services such as Interactive Data. These pricing services use Option Adjusted Spread (OAS) valuation methodologies to value these illiquid bonds but the primary inputs is the benchmark curve which is then overlaid to include credit spreads, duration, callable options and other factors. If you believe that the benchmarks indices exhibit stale pricing, then it would follow that the bond valuation that is driven of these benchmarks would also lag the ETFs.

But, how big an issue is this pricing risk for mutual funds compared to ETFs?

We (GridLex) analyze large data sets to provide investment, trading and risk management insights to clients. As part of our municipal bond and fund analytics service, we monitor the underlying portfolio holdings of more than 200+ muni mutual funds and ETFs that control more than 80% of mutual fund and ETF assets. One element of our liquidity analysis examined trading data for the underlying muni fund holdings and ETFs for a given period and determines what percentage of the underlying bond holdings have not been traded in the past 90 days. For example, if a fund held a bond – ABC- and if that bond was not traded in the past 90 days, it was considered illiquid.

Funds with a high percentage of assets that have not been actively traded would use non-market based pricing for a significant portion of their assets and as a result would run the highest risk of having stale pricing. The 90 day inactive trading is a conservative baseline, since most ETFs and funds would need to use non-market based pricing sometimes even if the bonds have not traded for a day. In the current volatile period, even short durations of non-market based pricing impact overall returns.

To examine the effects of illiquid assets on stale pricing and returns, we picked two mutual funds with the most illiquid assets in their peer group – Nuveen Intermediate Tax Free Fund (FMBIX , FAMBX , FMBCX) and Thornburg Intermediate Municipal Fund (THIMX, THMCX) – and compared them to two of the largest ETFs with a similar profile – S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB) and SPDR® Nuveen Barclays Capital Municipal Bond ETF (NYSEARCA:TFI).

Although, our entire analytics were across a much larger universe, for illustrative purposes, the smaller cohort group was selected based on funds with similar duration, national scope and investment profiles. We examined the illiquid assets, returns, effective duration, returns and SEC yields for this group and have shared the data in the below table.

Fund Ticker

Fund Name

% of Underlying Bonds Not Traded in 90 Days

Effective Duration

1 Year Return Pre Load Return (12/31/2010)

SEC Yield (12/31/2010)


Nuveen Intermediate Tax Free Fund


6.49 Years




Thornburg Intermediate Municipal Fund


6.3 Years



ETF Ticker

ETF Name

% of Underlying Bonds Not Traded in 90 Days

Effective Duration

1 Year Market Price Returns (12/31/2010)

SEC Yield (12/31/2010)


S&P National AMT-Free Municipal Bond Fund


7.18 Years


3.67% (02/08/2011)



Nuveen Barclays

Capital Municipal Bond ETF


9.46 years



The benchmark index for this group was the S&P National AMT- Free Municipal Bond Index (2.31% return for 1 year) and Barclays Capital Municipal Managed Money Index (1.64% return for 1 year). As is evident from the above table, the ETFs that are supposed to track their respective indices underperformed their indices whereas the mutual funds were nearly on par with the same indices and outperformed the ETFs. However, both these mutual funds have a much higher proportion of their assets in illiquid assets.

The primary implication is that if ETFs with a much lower percentage of holdings in illiquid assets still lag the indices, the lag could be much worse for mutual funds that have a much higher percentage of their assets in illiquid assets than ETFs.

Therefore, if you believe that ETFs are better indicators of pricing than indices (like Morningstar does), then investors need to be even more cognizant of the stale pricing that could generate extra returns by mutual funds with high illiquid assets when compared to ETFs.

At a minimum, investors need to do performance attribution of the underlying holdings to understand the liquidity levels of the underlying bond holdings and see if the additional illiquidity is generating higher returns than comparable ETFs. They also need to understand whether the additional returns are being generated simply because of stale non-market based pricing of illiquid assets, or if the performance being driven by better duration, credit and yield characteristics of the underlying fund portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This material is for for information purposes only. We are not recommending or soliciting any action based upon it; nor is this construed as a recommendation, an offer to buy/sell, or the solicitation of an offer to buy/sell any product or instrument. The material is based upon information we consider reliable but do not represent as accurate or complete. We or the persons involved in the preparation of this material may, from time to time, have long or short positions in, and buy or sell, securities, futures, or options identical or related to those mentioned herein.