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  • Muni Nation

    The Efficacy of Indexation

    S-Network Global Indexes , Digital Marketing Manager
    June 18, 2019
     

    Why Municipal Bond Closed-End Funds?

    The most unique characteristic of the S-Network Composite Municipal Bond Closed-End Fund Index (TICKER: CEFMX or “the Index”) is the exposure it provides—it is comprised of 63 closed-end funds that invest in municipal bonds. As a result, the dividend income derived from CEFMX is typically free from federal income taxes.

    CEFMX can offer a number of additional benefits. Because muni bond closed-end funds are not required to make redemptions, they do not need to hold cash in reserve for such occasions. By the same token, they can invest in less-liquid securities, including private placements, which typically offer slightly higher yields and are generally less exposed to the ups and downs of market turbulence.

    Most muni bond closed-end funds are actively managed, which is another important characteristic, because the managers employ proprietary investment strategies aimed at enhancing yield. Many muni bond closed-end funds employ leverage, whereby they borrow against their assets to buy additional assets in order to enhance yield.

    A potential downside of muni bond closed-end funds is that they often trade at discounts to their net asset values (NAVs). These discounts occur precisely because the funds do not offer redemptions at their NAVs. But opportunity can potentially be found in these discounts. In turbulent markets, the discounts tend to widen and when market stability is restored, the discounts tend to narrow. Buying muni bond closed-end funds at a discount increases the yield on their market prices and can potentially provide additional return when discounts narrow.

    S-Network Municipal Bond Closed-End Fund Index: Historical Discounts/Premiums
    As of March 31, 2019
    Historical Discounts/Premiums

    Source: S-Network Global Indexes.


    Diversifying Risk

    One of the biggest problems with muni bond closed-end funds, however, is the age-old investment problem of picking the right fund to include in one’s portfolio. A fund that cuts its dividend, for example, may likely experience a decline in price, thus negating the higher yield that the muni bond closed-end fund might have provided.

    The main strength of CEFMX is the diversification it offers. The portfolio currently consists of 63 individual muni bond closed-end funds, managed by 14 of the most prominent asset managers in active municipal bond investing, such as BlackRock, Nuveen, Invesco and Eaton Vance. Each manager employs their own unique investment strategy.

    Constituent weights in CEFMX are capped at 8%, so individual fund risk can be substantially mitigated. Of course, diversification comes at a price. It is certainly possible to get lucky, pick a single fund and enjoy a slightly higher yield than CEFMX offers. That is a personal decision based on risk preferences and the analytic resources at one’s disposal.

    S-Network Municipal Bond Closed-End Fund Index: Manager Distribution
    As of March 31, 2019



    Manager Distribution

    Source:  S-Network Global Indexes.


    S-Network Municipal Bond Closed-End Fund Index: Sector Distribution

    As of March 31, 2019
    Sector Distribution

    Source: S-Network Global Indexes.


    Constituents Chosen Based on Objective Criteria

    As a composite index, CEFMX includes every U.S.-listed muni bond closed-end fund with assets under management (AUM) greater than $100 million that fits into its selection criteria. Further screens are applied to define criteria for liquidity, expense ratio and discount/premium to NAV. The index rules governing all of the factors that are applied to the selection of constituent funds provide another valuable dimension of potential risk mitigation.

    Index performance can be compromised, however, through high levels of turnover. This is especially true in the muni bond closed-end fund market, where liquidity is often limited. To deal with this factor, CEFMX employs buffers that can prevent high turnover rates related to its semi-annual reconstitutions. For example, a constituent must have at least $100 million in AUM to be selected for inclusion in CEFMX, but once in the index, the constituent’s AUM must fall below $90 million to be dropped from the index. Similar buffers for liquidity criteria are also applied. As a result, CEFMX has maintained very low turnover rates throughout its history, thereby mitigating a potential performance drag.

    Importantly, muni bond closed-end funds with high expense ratios are excluded from the index, using a dynamic threshold based on the 30-day LIBOR1. This keeps the expense ratios—including the cost of leverage—from exceeding industry norms by an excessive amount.


    Capitalizing on Discounts

    The CEFMX rules for selection seek to produce a dependable and cost-efficient index. Rules governing the weightings of CEFMX constituents are also applied. Unlike most stock market indexes, which weight constituents based on their market capitalizations, CEFMX weights its constituents based on their total net assets. Since most muni bond closed-end funds trade at a discount to NAV, this weighting methodology can produce a more accurate representation of the holdings, compared to that of   traditional market cap weighting, which could favor muni bond closed-end funds selling at premiums or rich relative valuations.

    CEFMX also builds a smart beta component into its weighting methodology. Simply put, weights are adjusted (at quarterly rebalancing) to give the closed-end funds with the highest discounts the highest weights and to reduce the weights of closed-end funds trading at a premium to NAV. This is a technique often used by professional closed-end fund investors, because closed-end funds trading at a discount tend to revert to the mean.


    S-Network Municipal Closed-End Fund Index: Premium/Discount Weighting Methodology
    As of March 31, 2019

     Discount  Threshold  Adjustment Factor
     Discount   > 6%  30% increase
     Discount   > 3% and < 6%  20% increase
     Discount   > 0% and < 3%  10% increase

     Premium  Threshold  Adjustment Factor
     Premium  > 6%  30% decrease
     Premium  > 3% and < 6%  20% decrease
     Premium  > 0% and < 3%  10% decrease

    Source: S-Network Global Indexes.


    What Does It All Mean?

    The overall architecture of CEFMX uses custom rules-based indexing methodology to capitalize on the advantages inherent in muni bond closed-end funds, while diminishing the impact of their flaws. The resulting characteristics of CEFMX can offer broad diversification, in terms of jurisdictional exposure and quality, which tilts strongly toward investment grade.

    As of March 31, 2019, the highest single-state exposure in CEFMX was to Illinois at 11.72%, followed by California at 10.18% and Texas at 9.67%. Exposure to Puerto Rico was a mere 0.73%.  


    S-Network Municipal Bond Closed-End Fund Index: State Distribution
    As of March 31, 2019
    State Distribution

    Source: S-Network Global Indexes.

    Furthermore, CEFMX maintains high standards of credit quality, with approximately 64% of the underlying holdings maintaining credit ratings of A, AA or AAA.


    S-Network Municipal Bond Closed-End Fund Index: Credit Quality Distribution
    As of March 31, 2019
    Credit Quality Distribution

    Source: S-Network Global Indexes.


    Conclusion

    CEFMX is a composite index, including all the municipal bond closed-end funds that meet its general listing, size and liquidity requirements. The index does not limit the components that may come from a particular municipality or manager, nor does it pick them based on the highest yield. CEFMX instead casts a wide net, seeking to maintain representation of the bulk of the U.S. municipal bond market, and improve performance using its weighting methodology, which modifies the net-asset weighting of the closed-end funds according to their discounts or premiums.

    Perhaps most importantly, CEFMX is not a municipal bond index per se. A municipal bond index would hold individual municipal issues chosen in a mechanistic way. Such an approach might leave one vulnerable to spikes in interest. Because each of the underlying muni bond closed-end fund constituents of CEFMX is actively managed, interest rate risk is addressed, thereby potentially providing some added degree of protection.

    To gain access to this investment opportunity consider VanEck Vectors® CEF Municipal Income ETF (XMPT) which seeks to track the price and yield performance of S-Network Municipal Bond Closed-End Fund Index (CEFMX). XMPT is designed to offer investors the potential for tax-exempt income, diversification and access to closed-end funds trading at discounts.

    ADDITIONAL DISCLOSURE  

    1London Interbank Offer Rate (Libor) refers to the benchmark used by banks, securities houses and investors to gauge the cost of unsecured borrowing in the money markets for various periods of time and currencies.

    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 Fund 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 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.

    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. 

  • IMPORTANT MUNI NATION®DISCLOSURE  

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    VanEck does not provide tax, legal or accounting advice. Investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service.

    Please note this represents the views of the author and these views may change at any time and from time to time. MUNI NATION is not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue. Non-VanEck proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck. MUNI NATION is a trademark of Van Eck Associates Corporation.

    All indices listed are unmanaged indices and do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in a fund. Certain indices may take into account withholding taxes. An index’s performance is not illustrative of a fund’s performance. Indices are not securities in which investments can be made.

    The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt municipal bonds with a maturity of at least one year. The AAA and BBB indices are sub-sets of this broader index.

    Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Bonds and bond funds will decrease in value as interest rates rise. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.

    The income generated from some types of municipal bonds may be subject to state and local taxes as well as to federal taxes on capital gains and may also be subject to alternative minimum tax.

    Diversification does not assure a profit or protect against loss.

    Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of a fund 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.