Your investment in municipal debt isn’t merely just buying and selling those instruments and capitalizing on coupons, but also about primarily looking at the composition of your entire portfolio and how it is managed over time.
A municipal debt portfolio should be analyzed in terms of its composition and the portfolio execution construction strategy. For instance, municipal debt portfolios containing single-state-specific debt instruments would be an attractive investment option for high earners, since the income from such a portfolio is generally exempt from federal and state taxes. Therefore, investors from high-taxing states like California, Hawaii and New York have been more inclined toward seeking out municipal debt within their respective states.
On the other hand, it is important to analyze whether your municipal debt portfolio is actively or passively managed. For many investors, active and passive management strategies can be completely dichotomous and worth reviewing for their advantages and potential disadvantages. Whereas active management can help you be better prepared for potential future downturns, low-cost passive municipal bond funds can be a cost-effective way to improve their risk-adjusted returns.
In this article, we will take a closer look at both management strategies and uncover the potential value added to one or the other.
Keep our Glossary of municipal bond terminologies handy to familiarize yourself with different concepts commonly used by municipal investors.
Active and Passive Investment Management Strategies
Since the early 1990s, index-based investing, also known as passive investing, has been quite popular amongst investors looking to mirror an index and copy the market returns for an individual portfolio. A passive investor doesn’t want to follow market trends, read financial disclosures/documents or study particular sector, and is instead focused on investing money into a prebuilt portfolio or index fund that mirrors the economy and trusts that economy will grow.
On the contrary, an actively-managed portfolio is comprised of many different investment instruments: mutual funds, ETFs and individual stocks or bonds, and these instruments are actively traded by the fund manager to capitalize on market inefficiencies. The whole purpose of an active strategy is to beat market returns and present an added value for active investors.
Listed below are a few of the many different benefits of both strategies:
- Offers relatively low management fees as there is no active trading on these portfolios and the funds simply mirror the index.
- Index funds tend to buy and hold their underlying assets; this technique helps with lowering the capital gains tax for investors.
- Passive strategies also provide better transparency on the underlying securities to investors due to minimal buying and selling of the securities.
- Although active investing strategies come with management fees, the fund managers managing these funds serve as the risk managers and return enhancers for the portfolio.
- These funds aren’t tied to a particular index, and so portfolio managers have the flexibility to buy and sell underlying securities at any given time for a justifiable cause.
- Investors can rely on the active management of their portfolio to better position their holding for upcoming economic events and potentially ward off big losses.
Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.
Passive Approach to Municipal Bond Funds
In the municipal debt markets, investors are primarily looking for a steady growth/income of their portfolio while still being able to attain the tax-free income advantage. Hence, the passive approach can be an ideal investing strategy for returns and cost-effectiveness. In terms of portfolio returns, index municipal bond funds have done extremely well and often beat out their actively managed counterparts while saving huge margin on the management fees. For instance, Barclays Municipal Intermediate 8-12 year Index emerged as one of the top indexes that returned over 35% in the past five years. This return topped the returns of several actively managed portfolios.
As previously mentioned, the important fact to keep in mind is active portfolio fees, i.e. 12b-1 fees that will cut into your overall portfolio returns. It’s also critical to emphasize that fees are charged to a portfolio irrespective of its performance or ability to beat market or sector indexes. For example, passive/index strategy returns have been 7.5% on a portfolio, whereas an active portfolio manager was able to beat market returns and performed at 8.3% on a $100,000 portfolio. If active management fees are 1.20% and passive fees are minimal at 0.25%, the passive strategy performs better by returning $150 more than the active strategy.
In addition, active investing strategies can add a significant value in equity markets or niche market spaces like international equities or specific sectors like tech. However, in municipal debt funds, comparatively, there aren’t many variables other than interest rate risk and credit risk to justify the active management fees for municipal debt portfolios.
That being said, as markets evolve, regional and state investments are becoming more interlinked with the global economy. This can potentially require investors to give up index-based investing and instead explore active investment management tools. In an actively managed municipal debt portfolio, the manager can be aware of all the intricacies of the underlying issuers and the potential problems they may face in the near future and, therefore, act accordingly, unlike passive strategies. As a result, actively managed municipal debt funds can attract some of the more sophisticated investors who might want to explore different themes within the municipal debt space to enhance risk-adjusted returns or improve liquidity.
Check out how, under certain circumstances, actively managed municipal bonds can make more sense to investors here.
Check why muni bond investors prefer active over passive here.
The Bottom Line
Given the dynamic nature of investment markets, investors should carefully weigh their options and consider the trade-off between active and passive investment strategies. Where active investment strategies charge enormous management fees on investable assets, they can certainly play an important role in enhancing your returns and mitigating/managing market risks, whereas passive investment strategies can help you save thousands of dollars on management fees and return comparable returns, but they can also expose you to resource misallocation and market risk.
Check out the different ways to invest in muni bonds to stay up to date with current investment strategies.