Why active management is essential in the municipal bond market

There are inherent challenges in replicating a fixed income index, particularly for municipal bonds. Why? The USD 4.2 trillion¹ market is highly fragmented with around 50,000 different issuers.² To traverse this vast and diverse market, we believe that an active approach is essential.

As a refresher, passive strategies aim to mirror the performance of an index in an effort to generate a market-like return. Conversely, active strategies seek to generate alpha, or returns exceeding the benchmark, resulting in a composition that differs from the index.

Complexities of index replication

With thousands of small issuers, full passive replication is difficult, if not impossible, in the municipal bond market. Therefore, a passive manager in this space typically employs statistical sampling to help replicate the characteristics of an index, such as sector exposure, credit quality, and duration.³

But it is challenging to exactly mirror the benchmark due to index rebalancing and some issues not being liquid enough or available in the right size. These differences, together with transaction costs and cash flow disparities, can contribute to tracking error⁴ relative to the benchmark, which has tended to be high compared with a passive equity strategy.⁵

Key factors that underpin an active approach 

1. Large opportunity set

Active managers can benefit from a larger and more diverse universe of municipal bonds, as certain passive approaches could exclude significant segments of the market. A passive investment approach confines a manager to the benchmark they are aiming to replicate, resulting in the exclusion of bonds outside that index.

Since passive muni managers typically track indexes that are investment grade only, high yield municipal bonds are often omitted. Bonds in less liquid sectors, such as housing and industrial revenue/pollution control (IDR/PCR) may also be excluded, as are alternative minimum tax (AMT) bonds, since they generally are not part of the benchmarks that municipal passive managers track. 

In contrast, active managers can capitalize on potential alpha⁶ opportunities in these segments. For example, high yield muni bonds offer the opportunity to generate more income than the index. However, we believe fundamental research is essential to assess whether the additional yield is adequate compensation for the higher risk associated with high yield and less liquid bonds.

2. Freedom around investment decisions

The freedom of choice around what to own and in what size is a major benefit of an active approach, in our view.

"The freedom of choice around what to own and in what size is a major benefit of an active approach, in our view."

With autonomy over sector allocation and security selection decisions, an active muni manager can choose to overweight segments of the market they find appealing or underweight areas they consider less attractive. In some cases, an active manager may choose not to hold a segment of the market in their portfolio at all. For example, favoring revenue bonds, which are only secured by the revenue of the project behind it, over general obligation (GO) bonds, which are a form of long‑term borrowing in which the state or local government issuer pledges its full faith and credit to their repayment.

Flexibility can be particularly important in periods of volatility as an active muni manager can respond to the environment and potentially benefit from tactical changes, while passive approaches must keep allocations static and in line with the benchmark.

Some active managers have more flexibility over the level of cash they hold and tend to run larger cash balances than passive managers. This means that when market dislocations arise, like during the coronavirus pandemic and more recently with the tariff shocks, active managers may be in a good position to deploy that cash to take potential advantage when prices are cheaper. Higher cash balances could cause a cash drag (reduction in returns from holding cash instead of being invested), however. 

3. Control over risk exposures and level of risk

An active muni manager typically has more flexibility over risk exposures—credit, duration, etc.—and the overall level of risk in a portfolio. Therefore, if there are concerns around a particular sector or obligor, an active manager may seek to mitigate risks by underweighting that segment or avoiding holding that specific obligor in their portfolio entirely.

They also may benefit from the ability to manage their duration profile, which is particularly important when interest rate expectations are rapidly changing. A passive approach, by contrast, must keep a duration profile and sector/security weighting that is in line with the benchmark it is aiming to replicate regardless of the market environment.

4. Potential for outperformance with lower volatility

Across different muni approaches (short, intermediate, long, and high yield), active municipal bond managers historically outperformed passive muni managers on average. As shown in Figure 1, across four Morningstar categories, the average active manager outperformed the average passive manager in most time periods analyzed—including the 3-, 5-, 7-, and 10‑year horizons ending May 31, 2025.

It is important to note that the outperformance of active over those time periods was generally achieved with lower standard deviation of returns compared with passive, except in a small number of cases.

"...indices can sometimes have large concentrations, which is a risk."

Indices can sometimes have large concentrations, which is a risk. Indices typically weight holdings based on the market value of an issuer’s outstanding bonds. This means that issuers with the largest amount of debt typically garner the largest allocations in passive approaches. These large issuers may not always be attractive from a risk/reward perspective.

Considerations

It’s important to emphasize that choosing an active muni manager does not guarantee outperformance, higher returns, or reduced risk. Active investing typically involves higher costs compared with passive approaches. There is also a risk that an active muni manager may make a wrong call regarding a particular security, sector, or duration bias. This could sometimes result in underperformance relative to the broad market or comparable passive peers with similar objectives. Both investment styles and the various investment vehicles have their benefits and drawbacks, which investors need to consider before deciding which approach best suits their needs.

The importance of active in today’s dynamic markets

Overall, we believe there is a compelling case for taking an active approach to investing in municipal bonds, particularly in the current climate of heightened policy uncertainty and concerns over tariffs. It allows for investment decisions to be driven by fundamental research, not dictated by what is in the index. It is essential to fully understand an issuer and the potential risks and rewards involved with investing.

This depth of insight is especially important given prospects for a slowdown in economic activity, which could lead to credit fundamentals deteriorating, albeit from a strong base.