Cost efficiency is an important element of portfolio construction, but while minimizing costs is a sensible investment objective, within municipal portfolios, an overemphasis on fees may ultimately be counterproductive for some investors.

Passive municipal strategies offer exposure to the broader municipal market at a seemingly negligible cost relative to active municipal strategies. However, these strategies tend to exclude significant portions of the investible universe, have inherent structural index biases, and lack the flexibility to exploit market inefficiencies. 

The growth of exchange-traded funds within active investment strategies has catalyzed significant asset growth in the municipal space. Investors have increasingly embraced municipal ETFs not only for the potential benefits of active management in a fragmented and inefficient market, but also for the structural advantages of the ETF wrapper.

Below, we explore key reasons why active management in the municipal bond market can provide some meaningful advantages — justifying its fees through a broader opportunity set, greater portfolio flexibility, and the potential for improved risk-adjusted returns.

Structural Limitations of Passive Municipal Strategies 

Passive municipal strategies are designed to replicate index performance at minimal cost. However, index construction methodologies often impose meaningful constraints on portfolio composition. Common exclusions include alternative minimum tax (AMT) bonds and sectors such as tobacco settlement bonds, housing, charter schools, prepaid gas, and health care.

While these exclusions are generally intended to simplify portfolio construction and reduce complexity, they can also narrow the investable universe, reduce yield potential, and limit diversification benefits, resulting in an unintended deviation away from the risk-return characteristics of the municipal asset class.

Capitalizing on Market Inefficiencies 

Despite its more than $4 trillion size, the municipal bond market remains structurally inefficient. Its fragmentation across more than one million individual CUSIPs, combined with a highly diverse issuer base and a predominately retail investor composition, contributes to persistent pricing inefficiencies across maturities, sectors, and credit tiers. Investor demand is often concentrated in highly rated, liquid securities and select portions of the yield curve, creating relative value opportunities in less efficiently priced segments of the market.

Active managers are well positioned to capitalize on these inefficiencies. Unlike passive strategies, which are bound by index construction rules, active managers can assess relative value, adjust duration exposure, rotate across sectors, and exploit supply–demand imbalances as market conditions evolve. Recent market dynamics have created opportunities in longer duration bonds, select new municipal bond issues (i.e., prepaid gas), and premium high coupon bonds with favorable call protection. Identifying and capturing these opportunities requires analytical rigor, flexibility, and security selection — active management capabilities that passive strategies generally cannot replicate. 

Active Management’s Edge in Municipal Markets 

The case for active management is reinforced by historical performance; below are the percentages of active municipal strategies that have outperformed passive municipal strategies over a 3-, 5-, and 10-year period.

Conclusion 

Passive municipal ETFs may be low cost, but they are not costless. While they offer cost efficiency, daily portfolio transparency, and enhanced liquidity, their broad-based approach to municipal market exposure can leave meaningful alpha opportunities untapped. In a fragmented, inefficient, and highly nuanced market, active municipal ETFs combine the structural benefits of the ETF wrapper with the flexibility to pursue opportunities where passive strategies may miss. We believe the more relevant question for investors may not be “What is the fee?” but “What opportunities am I missing?”

Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio’s value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil,all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity. Exchange-Traded Funds (ETFs): Trade like stocks, are subject to investment risk, and will fluctuate in market value. Shares of ETFs are bought and sold at market price, not NAV, and are not individually redeemed from the fund. The market price at the time of sale may be higher or lower than the fund’s NAV, and any applicable brokerage commissions will reduce returns. There can be no guarantee that an active market for the funds will develop or be maintained. Actively managed ETFs differ from traditional ETFs in that they do not seek to replicate or to track a specific index. As such, the ability of an actively managed ETF to achieve its objective will depend on the effectiveness of the fund’s portfolio manager. Municipal Bond: Investments in municipal instruments can be volatile and significantly affected by adverse tax or court rulings, legislative or political changes, market and economic conditions, issuer, industry specific (including the credit quality of municipal insurers), and other conditions. Because many municipal instruments are issued to finance similar projects, conditions in certain industries can significantly affect the portfolio and the overall municipal market.