Historically, investors resorted to mutual funds to maintain proper diversification for their portfolios and generate decent returns. In recent times, as strategies evolved, exchange traded funds (ETFs) have emerged as strong rivals to the mutual fund space. Bond ETFs, including municipal bond–specific ETFs, have provided diversification similar to mutual funds while being relatively more liquid and cheaper.

In this article, we’ll explore different strategies associated with muni bond ETFs, in particular diversified national muni ETFs, and how they compare to muni mutual funds.

Bonds have typically been viewed as a safer investment option for investors, especially when they are held to maturity. Due to this reason, individual muni bonds have often been used for diversifying portfolios. Amateur investors often don’t think of further segmenting their bond holdings based on critical factors like credit risk, maturity or geographic location.

Let us consider three different cases to better understand how muni bond ETFs can be a better alternative:

• Individual muni bonds: Investments in bond funds, unlike individual bond investments, cover a huge geographic footprint. For example, a short-term individual security like New York St Housing Finance Agency Revenue Affordable Housing bond holds a coupon of 1.85%. Now, this security may not have a huge interest-rate risk due to its shorter time horizon. But this is a very location-specific revenue bond that is still subject to credit risks and, worst-case scenario, default risk, wherein revenue streams take a hit and the city is unable to meet its obligations. You can check our Market Activity section to know the latest trades in the municipal bonds space.

• Muni bond mutual funds: On the other hand, a muni bond mutual fund like BlackRock National Municipal K provides a great deal of segmentation strength to its investors. The risk mitigation comes from different maturities and a bigger geographical footprint, such as the general obligation (GO) bonds from Alabama, Utah and Massachusetts. Historically, this fund has returned above 4% on average per year, albeit at an ongoing expense ratio of 0.53%.

• National muni ETFs: Along similar lines, a security like PowerShares National AMT-Free Municipal Bond Portfolio ETF is an ETF that provides a strong diversification in terms of maturities and credit risk as it encompasses munis across different geographies like Alabama, Chicago and Miami and covers several sectors like transportation, water, education and health. This ETF provides similar, if not better, segmentation and better liquidity for a much lower fee structure, 0.28%, than the mutual fund security mentioned above.

Where mutual funds are more state- and sector-specific in their strategies, national ETFs are less region-specific and are likely to be composed of different investment-grade municipal securities from different states, further mitigating the credit risk.

National municipal ETF structure not only provides risk mitigation through holding securities across different geographic locations, it also offers the flexibility to trade and a lower cost, making muni ETFs a more desirable option compared to mutual funds. Below, we’ll discuss some of these advantages over mutual funds:

• Better transparency of fund holdings: ETF managers usually provide a full list of their holdings for investors to review on a daily basis. This is a critical tool for national muni ETF investors when it comes to full portfolio customization. For example, an investor could see the ETF breakup on a daily basis and compare the performance metrics and credit risk of the underlying securities. The investor could also draw comparisons between multiple national muni ETFs, or also between national muni ETFs and other muni mutual funds or individual bonds, to make an investment decision. This type of detailed risk-return analysis is difficult to conduct on a regular basis with mutual funds, because they usually publish fund holdings on quarterly basis.

• Relatively lower cost: As discussed in the previous section, a similar segmentation and diversification strategy could cost you twice as much in a mutual fund structure as in an ETF structure (0.28% expense fee for ETF and 0.53% for the mutual fund). Consider this: instead of looking through expensive mutual funds, most of which specialize in regional municipal strategies (as a justification for their higher costs), national muni ETF investors can gain broad diversification across the US muni market at a fraction of a muni mutual fund cost. This has been made possible via the passive management strategy of ETFs, which leads to a comparatively lower turnover of underlying securities, thus lowering distribution costs and the overall expense ratio.

• Better pricing transparency: National muni ETF investors are able to see and base their investment decisions on real-time pricing data, allowing them to capitalize on the market inefficiencies throughout the day. This isn’t an available option for muni mutual fund or individual bond investors.

There are also some drawbacks in ETF investments, compared to mutual funds, which must be taken into consideration:

• Initial Cost: Since we know ETFs trade like equities, there is an initial commission cost that applies to every trade investors place to buy or sell ETFs. If potential national muni investors are looking to invest frequently in an ETF (a certain amount every month, for example), they can end up paying a lot more than if they had made a single large investment in the ETF.

• Premiums or discounts: Like mutual funds, national muni ETFs also have a stated net asset value (NAV). However, the supply and demand of shares in ETFs can cause the NAV to change, thus creating a premium or discount for investors to bear. National muni ETF investors must make a decision based on the risk appetite and investment holding period.

Check here to have a basic understanding of muni bond ETFs and some of the top muni bond ETFs that you can explore.

Browse our Moody’s Credit Research section to access credit reports for individual muni bonds. By becoming a premium member, you can have immediate access to up-to-date Moody’s analysis for the muni bond, state or sector of your choice.

As ETFs may seem like the better investment option compared to individual bonds (which lack diversification) or mutual funds (which have high expense ratios), potential national muni ETF investors must keep the following things in mind:

• ETF have low expense ratios due to passive portfolio management. In high market volatility or changes in economic conditions, ETF investors will need to stay extra vigilant and make appropriate shifts to their investments to mitigate risks.
• Investors looking to pitch in small amounts of monies to buy ETFs may end up paying far more than the actual ETF expenses. Every trade entails a commission fee, which can pile up with multiple orders.
• Investors must evaluate the NAV of ETFs before investing, as ETF prices can fluctuate during the day and deviate significantly from the actual NAV.

For any investor, their investment objectives, risk tolerance and time horizon determines whether they should invest in national muni ETFs, mutual funds or individual bonds.

The higher fees of mutual funds shouldn’t be the only deciding factor for investors, as they also provide active management along with other benefits. At the same time, the majority of national muni ETFs provide some great benefits that can be hard or expensive to achieve through individual bonds or mutual funds. There are national munis that implement low-cost risk mitigation strategies which aren’t region-specific like mutual funds, provide better transparency on their holdings, and offer investors intra-day tradability with real-time pricing information.

Be sure to check our Municipal Bond Investing section to keep track of the relevant investing strategies.