ETFs Go Double Tax-Free

The options for municipal bond investors have expanded greatly in the past several months. Just weeks after the first national municipal bond exchange-traded funds came to market, you can now find state-specific ETFs from each of three big players in this market: State Street (NYSE: STT  ) and its SPDR series funds, the iShares offerings from Barclays (NYSE: BCS  ) , and PowerShares. Each of the three sponsors has started with funds targeting two major markets: New York and California.

Fund Name

Inception Date

Expense Ratio

SPDR Lehman California Muni (AMEX: CXA  )

10/10/2007

0.20%

SPDR Lehman New York Muni (AMEX: INY  )

10/11/2007

0.20%

iShares S&P California Muni (AMEX: CMF  )

10/4/2007

0.25%

iShares S&P New York Muni (AMEX: NYF  )

10/4/2007

0.25%

PowerShares Insured California Muni (AMEX: PWZ  )

10/11/2007

0.28%

PowerShares Insured New York Muni

10/11/2007

0.28%

Tax benefits
New York and California make logical targets for state-specific muni ETFs for two reasons: They have high tax rates, and their large populations should enable the funds to gather sufficient assets to be profitable fairly quickly. In the future, there are likely to be additional muni bond ETFs for states such as Pennsylvania and Massachusetts, but smaller states like Montana and Vermont are unlikely ever to see such funds.

Income from a fund in an investor's state likely will be exempt from federal and state income tax. This tax exemption means investors should use their taxable accounts for an investment in these ETFs, rather than IRAs or other tax-favored accounts. For planning purposes, keep in mind that it is the income from these funds that can qualify for a tax exemption. Any capital gains an investor may realize from these funds will be subject to capital gains taxes.

Similar but different
The three funds have many similarities. All three sponsors have taken a sampling approach to tracking each fund's respective index, so each fund holds just a fraction of the bonds that comprise their indexes. With sampling strategies, the fund may fail to track the index precisely.

However, the funds from each sponsor have slightly different ratings for the bonds they will purchase and also track different indexes. The iShares funds track S&P indexes and simply require investment-grade bonds. The Lehman indexes followed by the SPDRs require an AA rating. The PowerShares funds have the most stringent criteria, as securities must be AAA-rated and insured to get in the index. The fund's prospectus indicates that this insurance will normally cover 80% of the fund's investments.

In general, the higher the ratings, the higher the credit quality, but that can work in reverse for returns as the lower rated munis generally pay higher rates.

Risks
Municipal bonds face a number of risks, including changes in market conditions and political risks related to changes in taxation and legislation. The bonds can also be affected by local business and economic conditions and the financial condition of the issuer or insurers of the bond. An additional risk for state-specific funds is that they are geographically concentrated and are affected by the economic and political environment of their specific state.

Benefits
In contrast to individual municipal bonds, which are difficult to trade efficiently, muni ETFs are likely to provide narrower spreads and provide an easy and relatively inexpensive way to get broadly diversified exposure to the tax-exempt market. Of course, investors should compare these options against taxable fixed-income funds before making an investment. After you compare the after-tax performance of all alternatives, the best-performing fund with the lowest fees should be the winner.

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