What explains the outperformance?

But what are the specific differences between MUB and PIMCO’s MUNI for example, that helped MUNI outperform. For one thing, the portfolio managers behind MUNI are not obliged to hold every single security in the index regardless of the credit quality of the issuer. This fact shows up in the portfolio composition of those two ETFs. Where MUB held a whopping 1,144 bonds as of Nov 16th, MUNI held a select 98 securities and GMMB held an even narrower selection of 22 securities. In terms of its top holdings, because it follows a cap-weighted index following the municipal bond market, it should come as no surprise that the largest holding of MUB was a California State Bond.  This is the classic “bums” problem that is a favourite argument of the fundamentally-weighted indexing proponents. Cap-weighted indices like the one that MUB tracks give more weight to issuers that issue more debt – in this case California. As a result, investors holding MUB end up with California bonds as their biggest holdings at a time when they are probably the riskiest. To prove the point, just over the past month, CMF – an ETF which tracks the California municipal bond market – has underperformed NYF – which tracks the New York municipal bond market – by more than 1.5%. So in contrast to MUB, a California issued bond was not to be found in MUNI’s top 10 holdings. That should provide some indication of the value of credit analysisdone by active managers from PIMCO for MUNI and from McDonnell Investment Management for GMMB.

How do Premium/Discounts compare?

Another area where the actively-managed ETFs seem to be performing better in this panicked market is in keeping the discount/premium from NAV to a minimum. In general, ETF shares trade at a premium to NAV when demand is high and trade at a discount to NAV when the demand is low. Bond ETF discounts were a big problem in 2008 when credit markets locked up. At one point in October 2008, the largest bond ETF at that time, iShares Lehman Aggregate Bond (NYSEArca: AGG), traded at an 8.9% discount.  Hence, that discounts in bond ETFs are definitely another metric that needs to be assessed in times of market stress.

According to the iShares’ website, MUB had a discount of 186 basis points to its NAV at the close on Nov 16th, a substantial discount given that the largest discount recorded for MUB in 2010 up till September was just 16 basis points. In comparison, PIMCO’s MUNI had a premium of 6 basis points as of market close on Nov 17th, a substantial difference. Grail’s GMMB though had a harder time, but still fared better than MUB as Grail’s website reported GMMB having a discount of 161 basis points as of Nov 17th.

Disclosure: No positions in above-mentioned names.

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