History has shown that when it comes to the cost/benefit tradeoff between active and passive management, bonds are different from equities – and this distinction may be especially striking for municipal bond strategies. On the surface, the argument that a lower-fee passive solution can support higher after-fee returns may seem reasonable and even compelling, particularly in an investment environment where returns are expected to be lower than in the past. But our years of managing investments in the complex, fragmented municipal bond market – with its often idiosyncratic risks and opportunities – have shown that an active approach may benefit investors in several important ways.
The first question investors must ask when considering their approach to investing in municipal bond funds is what they’re hoping to gain from this exposure, and for most, the answer is high quality, tax-efficient income with limited price volatility. But several characteristics inherent to rules-based passive strategies may run counter to these objectives.
Passive portfolios often don’t prioritize tax efficiency, to investors’ cost
In an effort to replicate an index, passive strategies tend to trade more frequently and at higher volumes. Such frequent rebalancing by passive municipal bond funds may lead to higher capital gains costs relative to those for active municipal managers, who have the freedom to tactically manage gains and losses (for instance, by seeking to harvest losses and enhance tax-exempt1 dividends) and are not bound to recognize capital gains associated with market value appreciation as part of a rebalancing process.
We’ve observed that passive strategies, on balance, often pay lower tax-exempt distributions than open-end funds with similar risk profiles, possibly as a result of higher costs associated with a rebalancing process. When looking at the active funds within the Morningstar Municipal Intermediate category, the advantage is marked: The median tax-exempt distribution yield is 141 basis points (bps) higher than the distribution yield for the passive funds within the category (and with a median expense ratio differential of just 37 bps). These higher tax-exempt distributions mean higher tax-exempt income for investors.
The highly fragmented muni market makes index replication costly and inefficient
The sheer size and complexity of the municipal market are also pertinent to the active-versus-passive question. With approximately 40,000 issuers and over 900,000 CUSIPs outstanding across a multitude of sectors, the muni market is highly fragmented relative to the corporate bond market. Replicating and managing to an index with thousands of constituents can be costly and inefficient, and trading dynamics are often unpredictable. An active approach to municipal portfolio construction has the potential to be superior to a rules-based process that aims simply to deliver municipal beta (at whatever cost).
We believe a robust credit research process is crucial. The municipal allocation is often considered a higher-quality component of an investor’s overall portfolio, where capital preservation and high quality income are key objectives. Yet despite relatively low historical default rates for the asset class, investors are coming to realize that the muni market is now a credit market. The decline of insurance from the marketplace (from roughly 60% of primary issuance in 2005 to less than 5% today, according to Thomson Reuters), along with states’ generally slow economic recovery from the Great Recession, has made municipal credit selection increasingly important. This is evidenced by multiple-notch downgrades of some of the largest obligors in the marketplace (Puerto Rico being a prime example, as we discuss below).
Index-based approaches may expose passive investors to outsize credit risk
Construction of municipal bond indexes is often shaped by each issuer’s outstanding debt in the marketplace. Therefore, municipal indexes often have the largest concentrations in the most indebted issuers. Such concentrations may contribute to volatility and expose investors to additional risk – and from a credit perspective, this tendency does not lend itself to optimal portfolio positioning.
The default of Puerto Rico offers a cautionary case in point. After Puerto Rico’s governor announced that the island’s debts were “not payable” in June 2015, the commonwealth made up roughly 32% of the Bloomberg Barclays High Yield Municipal Bond Index (see Figure 1). Today it represents around 11%, after many of the island’s securities dropped out of the index due to distressed or defaulted status, and this figure may fall even further as the island seeks to restructure its debt.
Active managers have a clear advantage in such cases. Free from these index constraints, they can avoid highly indebted issuers facing credit deterioration, while index-following passive strategies may be pressured into or out of such exposures upon a default or downgrade (likely during times when liquidity is thin).
An active investment process incorporating comprehensive bottom-up credit analysis is crucial to avoid potential land mines and related price volatility that may come with a 40,000-issuer market. Equally important is forward-looking evaluation (informed by a global research process that identifies regional, sector- and issuer-specific trends) to recognize issuers likely to experience positive credit momentum.
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Active liquidity management can help avoid buying high and selling low
Managing market liquidity, or the ability to efficiently buy and sell securities, is a critical component of municipal investment management. Supply and demand imbalances have been significant drivers of municipal market performance since the recession as heightened regulation has contributed to a decline in support from broker-dealers. At the end of 2016, brokers and dealers managed less than $20 billion of municipal assets, down from more than $60 billion in 2008 (see Figure 2). This decline has made it more expensive to buy and sell municipal securities relative to other traditional fixed income asset classes, and a further reduction of municipal market liquidity could contribute to more frequent bouts of volatility that could hurt passive managers disproportionally, in our view.
Passive strategies aim to replicate an index and remain fully invested at all times, which limits their cash flexibility. These strategies are often compelled to buy at the height of the market when valuations are rich, usually during periods when fund inflows are high (see Figure 3). Conversely, when the market is under pressure and funds experience redemptions, passive strategies must often sell at the lows of the market. We believe active strategies that tactically manage cash and liquidity stand to benefit disproportionately from the volatility induced by changes in demand.
Active municipal bond funds have outperformed passive funds since the recession
We’ve seen evidence since the recession that the factors discussed above are benefiting the performance of active municipal strategies, with the majority of active funds in each of the below Morningstar categories outperforming passive funds over the past five years, even when factoring in their marginally higher fees and despite having nearly a year shorter average duration (see Figure 4). Moreover, most passive funds in these categories underperformed their benchmarks as well.
At PIMCO we generally expect lower returns across asset classes in the coming years, and we believe excess returns will represent a greater component of municipal bond total returns than in the past (see Figure 5). At these lower absolute return levels, we understand investors’ impulse to save on expenses by leaning toward lower-fee passive strategies. But within the municipal allocation, we believe active strategies will better equip investors to meet their objectives, withstand market volatility and ultimately generate better risk-adjusted, after-tax returns than their passive counterparts.
1 The term “tax-exempt” cited herein refers to municipal bond federal tax-exempt income. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.