No matter the iffy track record of quantitative investing, it appears there’s no stopping its push into every corner of the financial markets.
Case in point: Van Eck Securities Corp. on Thursday launched the VanEck Vectors Municipal Allocation exchange-traded fund, with the ticker MAAX. That name correctly states that it invests in the US$3.8 trillion market for state and local government debt — but that’s very much only part of the story.
MAAX is an “ETF of ETFs,” which for the most part will be divvying up money among five other Van Eck muni funds. The portfolio weights are determined by — you guessed it — a quant model “that uses momentum, along with both duration and credit risk indicators, to tactically allocate,” according to a statement. “For investors looking for both tax-exempt income and enhanced risk-adjusted total returns, MAAX could be a compelling way to approach the municipal bond market.”
To say investors are looking for tax-free income lately is an understatement. Muni bonds have been on fire, precisely because their interest is exempt from income taxes. That perk attracted a flood of money during tax season because the new US$10,000 cap on state and local tax deductions left some individuals facing higher bills than they might have expected. A ratio of 30-year muni yields relative to long-dated Treasuries dropped this week to the lowest level in at least 18 years, signaling tax-exempt debt is as expensive as it has ever been on a relative basis.
So, yes, there’s ample demand for munis. Still, it’s worth asking: Why does this traditionally buy-and-hold market need an ETF that tactically allocates among other ETFs? If investors want steady, tax-free income, they can just buy a bond from their hometown or state, stash it away and collect interest until they get their money back at maturity. Big fund managers like Fidelity Investments, Nuveen and Pacific Investment Management Co. have websites devoted to calculating how to “ladder” a muni portfolio, one of the simplest investment strategies in the books.
Jim Colby, senior municipal strategist at Van Eck, says the fund is an answer to the question that’s been nagging all markets as of late: “Are active managers in the muni space consistently delivering outperformance?” The idea, he says, is to use passive ETFs that have a decade-long track record of mimicking broad indexes, “and put them in combination with one another to generate some alpha as well as strong income.”
That sounds perfectly fine in theory. And I think munis might lend themselves better to a momentum strategy than some other bond markets, given the tendency for sentiment to swing drastically one way or another as retail investors chase (or flee) performance. Plus, the vast number of issuers and the relatively scarce day-to-day trading make it a corner of Wall Street full of inefficiencies. At the very least, it doesn’t hurt to experiment with new ways to get people involved in buying state and local government debt.
Yet some caution is warranted. As I wrote in January, early results of quant-based investing in bonds have been mixed at best, even though the idea of combining the best parts of active and passive investing sounds like a no-brainer. Granted, this is a bit different, with MAAX rotating among a small subset of ETFs rather than having a factor model picking out potentially undervalued individual securities. Still, the strategy is only as good as the model. Additionally, the often-cited fear of a liquidity mismatch between bonds and ETFs still looms large, even if this fund buys only other ETFs.
MAAX ultimately makes sense for investors who want to buy into the entire muni market but don’t want the hassle of exiting junk bonds when the credit cycle turns, or having to manually extend duration when it looks as if interest rates are on their way down. Of course, being able to sit back and let the model do the work doesn’t come free — the gross expense ratio on MAAX is 0.65 per cent, almost double the rate on Van Eck’s high-yield muni ETFs. Colby says the firm will market the fund to institutional clients first.
If nothing else, MAAX proves once again that the quant revolution isn’t going away. It already came for muni-bond trading, and I’m sure that tax-exempt funds that buy individual bonds based on factor analysis are in the pipeline. More innovation and more choices are a good thing.
Don’t expect these trends to radically reshape the muni market anytime soon, however. It’s often called “sleepy” or “boring” for good reason. Sure, some strategies can probably squeeze out alpha. But many investors are happy enough just collecting their interest and protecting their money. That’s a crucial variable that quants ought to consider.