Daniel Sotiroff: Municipal bonds have historically been a tricky asset class for index-tracking strategies. The municipal-bond market is composed of tens of thousands of individual bonds, many of which are small and expensive to trade, meaning they can hurt returns and lead to high tracking error. But over the past several years, several index-tracking funds have proven that an index-tracking strategy can be executed in a cost-effective manner.
Two of our favorite index-tracking municipal-bond funds at the moment are Vanguard Tax-Exempt Bond ETF and iShares National Muni Bond ETF. The management teams at Vanguard and BlackRock both use a sampling approach to track the S&P National AMT-Free Municipal Bond Index. This means that they hold a subset of bonds from the index as a way to replicate important characteristics like yield, duration, and credit quality. In doing so, they can avoid bonds that are expensive to trade without sacrificing the fund’s overall performance. This approach has been effective so far as these two funds both delivered incredibly low tracking error over the past few years.
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Daniel Sotiroff does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.