Municipal bond exchange-traded funds (ETFs) have gone from zero to 60 miles per hour in just a few days. And the race continues.

Two weeks ago, not a single municipal bond ETF existed in the investment marketplace. Last week, both Barclays Global Investors of San Francisco and State Street Global Advisors (SSgA) of Boston began trading their own unique versions of municipal bond ETFs.

PowerShares Capital Management, an Invesco company, announced last month that it expects to begin trading two muni bond ETFs in October, one insured and one non-insured national municipal bond ETF based upon Merrill Lynch muni bond indexes. Van Eck Associates of New York is readying six different municipal bond ETFs under its Market Vector ETF Trust series: three are national muni ETFs with varying durations, one is a high-yield muni ETF and two are single-state munis focusing on California and New York.

Why the rush to debut municipal bond ETFs?

Ego has played a part, with each firm vying for the bragging rights of being the first to offer a municipal bond ETF. (Barclays beat out SSgA by three trading days.)

At the end of July, only 30 fixed-income ETFs existed, up from only six at year-end 2006, a fraction of the current 509 equity ETFs. SSgA, the trendsetting firm that launched the very first SPDR equity ETF back in 1993, launched five bond ETFs this past May.

Secondly, the demand among investors has been fierce over the past few years. "Munis have been one of the single most requested ETFs by advisers for the past five years," said Anthony Rochte, senior managing director of SSgA. The lack of transparency within the muni bond market has also contributed to increased demand for municipal bond ETFs, he said. SSgA created its new SPDR Lehman Municipal Bond ETF, which tracks the Lehman Brothers Municipal Managed Money Index, in June 2004.

That demand has been strongest among the financial adviser/registered investment advisory audience, which has been seeking for their clients a lower cost alternative to traditional municipal bond funds, whose expense ratios average at least five times that of the 20 basis points charged by the new SSgA muni ETF, Rochte said. He estimates that about 40% of SSgA's total ETF audience is comprised of financial advisers, with another 50% to 55% segment consisting of institutional investors and a smaller 10% of self-directed investors. "We think there's an appetite in each segment for muni bond ETFs," he added.

The needs of investors were forefront on the minds of executives at Barclays Global, which just debuted its iShares S&P National Municipal Bond Fund. "Investors have been looking for a simple and cost-effective method of gaining exposure to the municipal market, which is traditionally a less liquid and expensive marketplace," said Noel Archard, head of U.S. iShares product development, in announcing the new ETF.

"The iShares S&P National Municipal Bond Fund provides individual investors and their financial advisers with more tax efficiency, transparency and lower costs than traditional mutual funds," said a SSgA spokeswoman.

Individual investors who have historically bought individual muni bonds can now diversify and have national exposure with a single trade, she added. As for institutional investors, they "value the ability to short the ETF as a hedging vehicle for other municipal exposure, something that has never been done before," she noted.

The new iShares ETF is also very significant in that its underlying S&P muni index is not only brand new, but quite notably marks Standard & Poor's entree into the fixed-income index world. The new muni index is the first in a planned series of U.S. fixed-income indexes that the firm will introduce.

The new S&P muni bond index includes approximately 3,000 municipal bonds that the firm has culled according to specific criteria from its much broader, but not investable, Standard & Poor's/Investortools Municipal Bond Index of some 50,000 issues. As of Sept. 4, that newly created index had a total market value of over $305 billion.

Why did S&P decide to dive into the fixed-income index market? "There's no reason for us to feel restricted to equities," said David Blitzer, managing director and chairman of the index committee at S&P. "We think this is a very important contribution to municipal bond trading."

Beyond its array of equity indices, S&P has, in recent months, created other indices including two real estate indexes. "Fixed income is a huge market with the total amount outstanding bigger then the equity market," Blitzer noted. And fixed income indexes that will provide liquidity, work well to support exchange-traded funds, he noted.

S&P will be carving out more narrowly focused California and New York muni indexes shortly, and will be looking at indexes for other states with high income taxes, Blitzer said. "We are looking at various other areas of fixed-income; other segments that are unserved and will support investment services," he added.

As for whether the market really needs an array of municipal bond ETFs to satisfy its appetite, the jury is still out.

The introduction of muni ETFs is a reflection of the ETF industry in general and will fill a hole in the market. That could be particularly important for those who want to hold and trade a 100% ETF portfolio, said Sonya Morris, editor of the Morningstar ETF Investor.

"The ETF industry is now courting more [individual] investors and RIAs who want to incorporate ETFs into portfolios," she said. But Morris said she's taking a wait-and-see approach as to who will win the muni ETF turf war. "It will be interesting to see what happens in five years," she added.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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