By Michael Cohick
Director of Product Management
This blog aims to answer common questions about the VanEck CEF Muni Income ETF (XMPT), an ETF that seeks to replicate the S-Network Municipal Bond Closed-End Fund Index, offering investors diversified access to U.S. listed municipal closed-end funds. Using a rules-based approach, XMPT adjusts for average premiums and discounts, providing a transparent, tradable, and cost-effective investment option.
- What is the methodology behind XMPT?
- What factors influence premiums and discounts in closed-end funds?
- What are the underlying closed-end funds’ weighted average historical discounts compared to where discounts currently are?
- When do discounts signal attractive entry points for XMPT investors?
- Given the volatility and dividend cuts in municipal closed-end funds year-to-date, why might now be an opportunity for investors?
- Was XMPT being used as a tax swap opportunity for clients’ portfolios?
- How does XMPT fit within a portfolio?
- How can investors buy VanEck ETFs?
What is the methodology behind XMPT?
The VanEck CEF Muni Income ETF (ticker: XMPT or “Exempt”) aims to replicate the performance of the S-Network Municipal Bond Closed-End Fund Index (CEFMXTR), which tracks the performance of U.S. listed closed-end funds that invest in U.S. dollar denominated tax-exempt market. The index comprises four muni bond closed-end fund sectors: leveraged and unleveraged investment-grade strategies and leveraged and unleveraged high-yield strategies. It utilizes a weighting methodology based on each fund’s total net assets, adjusted for its average premium and discount (difference between the closing price and the net asset value (“NAV”)) over the past 90 days during quarterly rebalances.
Unlike open-end mutual funds or ETFs, the number of shares of a closed-end fund is fixed, which means that the price of the fund is determined by supply and demand in the secondary market. Unlike ETFs and mutual funds, closed-end funds don’t do primary market creations and redemptions to release the pressure of secondary market buying and selling, which, in an ETF helps keep large premiums and/or discounts from occurring. As a result, closed-end funds tend to trade at either a premium or discount to their NAV. XMPT’s index rules overweight exposure to funds trading at wider discounts and away from funds trading at a premium. By incorporating this modified net asset weighting, the index effectively manages the discount exposure for investors, essentially buying discounted assets and selling overpriced ones in a systematic, rules-based manner.
Closed-end funds must meet the following criteria for inclusion:
- Minimum $100 million in assets under management (AUM)
- Minimum monthly trading volume of 250,000 shares in the past six months
- Average daily trading volume exceeding $500,000 per day in the past three months
- Management fee below 1.25%
Approximately 85% of the fund and index are investment-grade, and XMPT distributes dividend payments monthly. By investing in XMPT, the investor gains diversification across underlying closed-end fund assets (muni bonds) and investment strategies, access to prominent active asset managers through a single trade, with the transparency and tradability of an ETF.
What factors influence premiums and discounts in closed-end funds?
The closed structure of these funds causes investor sentiment to be the main driver of discounts to NAV. Factors influencing sentiment include credit events, interest rate policies, headlines, liquidity, and changes in distribution rates.
In the U.S., rising interest rates and distribution cuts have been major concerns for muni closed-end fund investors. Several funds announced dividend cuts in the past year, primarily due to increased borrowing costs for leverage usage and the short-end muni yield curve inversion. Short-term rates (the rate at which the funds typically borrow) are currently higher than the middle part of the curve and only slightly lower than the long end of the curve. This means that borrowing in the short term to buy long-dated bonds is no longer a viable strategy to boost the yield in a given portfolio. Portfolio managers are stuck between adding risk by buying long dated lower-quality bonds or accepting a lower yield.
When funds reduce distributions, discounts typically widen. Although predicting distribution changes could help investors stay ahead, the premium/discount weighting in XMPT’s underlying index can capitalize on these dislocations. This approach facilitates buying discounted assets and selling those at premiums, offering a strategic advantage.
What are the underlying closed-end funds’ weighted average historical discounts compared to where discounts currently are?
Since the fund’s inception, the average discount of the underlying funds has been -5.05%, with the current discount hovering at around -12.5%. Throughout most of 2021, the underlying funds were at a slight premium, which began to widen out at the beginning of 2022, when the current rate hike cycle began. We have seen discount volatility since then, and we expect this to continue. But we believe investors may benefit from deploying cash into discounts at these levels.
When do discounts signal attractive entry points for XMPT investors?
Potential buying opportunities typically arise when closed-end fund discounts reach the long-term average. However, a particularly attractive total return opportunity has historically emerged when discounts hit or exceed -10%. Out of approximately 3,000 trading days since XMPT’s inception in 2011, this has occurred only 109 times, accounting for just over 3% of those days.
Premium/Discount: CEFs Held by XMPT
Before the pandemic, the discount had approached this magnitude only five times. On average, in the 11 months following a 10% discount, the fund experienced an average cumulative total return of 20%.
Given the volatility and dividend cuts in municipal closed-end funds year-to-date, why might now be an opportunity for investors?
Closed-end funds are inherently volatile, and the current fixed-income environment has made muni closed-end funds even more so. However, volatility seems to have become the new normal for the municipal market over the past five years. In the last year, most of the closed-end funds in the portfolio have cut their dividends, which has helped to widen discounts across the board. It’s also important to note that closed-end funds will boost their dividends when possible. A disciplined allocation approach could be appropriate given the historical returns of investing during wide discounts.
Although the current rate hike cycle may not be over, it could conclude before the year’s end. Historically, negative performance years for muni closed-end funds have been followed by strong recovery years, which could occur in 2023.
Was XMPT being used as a tax swap opportunity for clients’ portfolios?
We believe that XMPT’s diversified, discount-weighted approach offers a smarter investment strategy compared to trying to pick individual winners and avoid losers. Regarding tax swaps, muni-focused ETFs, including XMPT, were likely used as tax-loss harvesting tools throughout 2022, capturing at least a portion of the related fund flows.
How does XMPT fit within a portfolio?
XMPT serves as a long-term strategic allocation for investors seeking a high level of tax-exempt income while diversifying away from traditional high-yield (below investment grade) exposures. We believe it complements, rather than replaces, below investment-grade muni bonds or muni bond funds.
XMPT offers three key benefits:
- High level of tax-exempt income
- Diversification by asset, strategy, and manager
- Opportunity to capitalize on inefficiencies in the closed-end fund market, enabling the purchase of assets at discounts to NAV
Originally published by VanEck on May 19, 2023.
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This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities/financial instruments mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its employees.
S-Network Municipal Bond Closed-End Fund IndexSM is calculated and maintained by S-Network Global Indexes, Inc. S-Network does not sponsor, endorse, or promote the Fund and bears no liability with respect to the Fund or any security.
Index performance is not representative of fund performance. Indices are not securities in which investments can be made. It is not possible to invest directly in an index.
The Fund’s performance, because it is a fund of funds, is dependent on the performance of the Underlying Funds. The Fund is subject to the risks of the Underlying Funds’ investments, and the Fund’s shareholders will indirectly bear the expenses of the Underlying Funds. In addition, at times certain segments of the market represented by the Underlying Funds may be out of favor and underperform other segments. The shares of a closed-end fund may trade at a discount or premium to its net asset value (“NAV”). Additionally, the securities of closed-end investment companies in which the Fund will invest may be leveraged. As a result, the Fund may be indirectly exposed to leverage through an investment in such securities. An investment in securities of closed-end investment companies that use leverage may expose the Fund to higher volatility in the market value of such securities and the possibility that the Fund’s long-term returns on such securities (and, indirectly, the long-term returns of the Shares) will be diminished.
An investment in the VanEck CEF Muni Income ETF (XMPT) may be subject to risks which include, among others, market, municipal securities, high yield securities, credit, interest rate, call, tax, liquidity, leverage, anti-takeover measures, non-diversified, investment restrictions, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, non-diversification, and concentration risks, all of which may adversely affect the Fund. A portion of the dividends you receive may be subject to the federal alternative minimum tax (AMT). There is no guarantee that Fund’s income will be exempt from federal, state or local income taxes, and changes in those tax rates or in alternative minimum tax or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
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