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Passive ETFs have become a larger component of the equity world, but for fixed income, and in particular municipal bonds, we believe active management will remain beneficial across market cycles."
Since their first U.S. listing in 1993, exchange-traded funds (ETFs) have transformed from a clever financial novelty to one of the most popular investment vehicles in modern capital markets. Early growth and mass use of ETFs emerged in equity markets, primarily in passive strategies that mirrored the S&P 500 Index or other broad equity benchmarks. With the rise of passive equity ETFs, coupled with the emergence of ETFs into other asset classes including fixed income, investors began embracing passive ETFs for their municipal bond exposure. But given the differences in the underlying securities and unique market dynamics in the equity and municipal markets, investors began to realize that many of the advantages of passive equity strategies are not realized for passive municipal offerings. As a result, active municipal ETFs have become more popular over the last several years because they can provide benefits unavailable from passive ETFs.
Downsides of Passive Municipal ETFs
- Challenges to Index Replication: The number of issues within the municipal bond index and infrequent trading of many constituents post initial issuance, may hinder close replication of index exposure. Existing passive offerings may not always achieve index replication and low tracking error, which are major selling points for passive equity ETFs.
- Less Credit Oversight: Compared to active managers, passive municipal strategies may focus less on credit fundamentals or outlook when purchasing securities for their portfolios. A passive mandate to purchase only requires inclusion in the index and meeting certain criteria. This method of investing increases the chances of overlooking signs of potential downgrade or default risk of portfolio holdings, while also ignoring potential credit opportunities.
- No Positioning for Seasonality: Periods of strong or weak market technicals are major drivers of municipal performance most years. This seasonality is driven by several factors, including fund flows, reinvestment capital and primary market issuance. While active managers may seek to position their portfolios accordingly to take advantage of these longer run trends, passive portfolios may have less flexibility to adapt and capture alpha1.
- Limited Ability to Rebook Yields: Fluctuation of interest rates over time creates opportunities for rebooking purchase yields at higher prevailing market levels. This in turn can be a leading contributor to higher dividend yields for active funds. In this scenario, active managers tend to place more focus on selling existing holdings and purchasing new securities with higher purchase yields. Passive managers, who are buy-and-hold investors, may be less proactive in rebooking into higher yields. Ultimately, this may contribute to a large difference in total return between these two styles of portfolio management. Both 2022-2024 and the first three months in 2025 provided ample opportunity for rebooking yields and tax-loss harvesting.
- Excluded Sectors and Market Segments: Passive municipal ETFs tend to exclude several large market segments from their portfolios, including bonds subject to the alternative minimum tax (AMT) or sectors like housing, healthcare or pre-paid gas bonds. Therefore, passive municipal ETFs may not be giving investors true market exposure, as they do in equity markets, and passive portfolios tend not to invest in areas where active managers often find value.
Side Note: To be fair, simply choosing an active ETF does not guarantee outperformance for one’s municipal bond exposure. There are some potential downside by going active; active ETFs tend to have higher costs than their passive counterparts. There is also the risk the active manager may get market, duration2, or sector calls incorrect. These downsides are not unique to the municipal bond market, but rather are characteristic of active investing in general. Investors must consider the pros and cons of each type of investing style when selecting the type of investment that is right for their circumstances.
Bottom line: Passive ETFs have become a larger component of the equity world, but for fixed income, and in particular municipal bonds, we believe active management will remain beneficial across market cycles. Furthermore, it is important to select an active manager for municipal bond exposure with a demonstrated track record of providing characteristics that passive ETFs typically lack, such as credit oversight, positioning for seasonality, rebooking into higher book yields when possible and investing across the entirety of the municipal bond universe.
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