Choosing a municipal-bond fund can be a piece of cake -- if you start by choosing the fund company before you look for the fund. Muni-bond funds are often team efforts, making the manager less important than the group behind the fund. Typically, a fund company will run all its muni funds with the same core philosophy and the same underlying fee structure. There's tremendous uniformity of quality and strategy within a fund company's muni operations.
It gets easier
Now I'm going to make it really easy by telling you to limit your search to just two fund companies (if you are a no-load investor). That's right, Fidelity and Vanguard are the only fund companies you need to know when you're looking for a tax-free bond fund. If you're familiar with the prowess of great bond firms such as BlackRock, Pimco and Western Asset, you may wonder why they aren't in the running. The reason is that they mostly manage money for giant institutions, such as pension funds, and pension funds don't need municipal bonds' tax advantages.
That narrows the field to fund companies focused on individual investors. Although there are many worthy competitors, they don't measure up to Vanguard and Fidelity. If you look at rankings, you'll see funds from other shops, such as Oppenheimer, that have been hot lately. However, many of those at the top of the lists run very aggressive strategies, and most muni-bond investors are risk-averse types. Fidelity and Vanguard understand that. On the more cautious side, you can find solid choices at T. Rowe Price and American Century. But the funds cost a bit more, and their performance hasn't quite measured up. In addition, Vanguard avoids bonds that may be vulnerable to the alternative minimum tax (AMT), thus protecting you from tax risk. Fidelity Tax Free Bond fund is AMT-free, but many of its other funds are not.
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Vanguard has the lowest expense ratios among muni funds, and Fidelity is number two. Because of their big expense edge, both companies can avoid big risks and still deliver superior returns. In fact, they have built their strategies around that idea. Vanguard, in particular, plays it really close to the vest while trying to add value.
Fidelity's muni group avoids interest-rate bets by keeping a fund's duration (a measure of interest-rate sensitivity) in line with its benchmark. But managers try to add value by doing research to pick bonds that should modestly outperform similar issues. Do that enough times and it can add up to strong performance. In fact, Fidelity has the most impressive muni operation I've seen. It has great quantitative analysts who tease out inefficiencies to add value while stress-testing various scenarios to ensure that portfolios are well protected against any risks. In addition, Fidelity has good traders and issue pickers. Put it together, and Fidelity is capable of making up a handicap of 0.2 to 0.3 percentage point on expense ratios it typically faces versus Vanguard.
The proof is in the performance. Both Vanguard's and Fidelity's muni funds excel. Of the 30 no-load muni funds between the two firms, 29 have returned better than their category averages over the trailing five years to May 1. Overall, Fidelity's muni funds are in the top 17% over the past five years and Vanguard's are in the top 21%.
Just a few decisions
To my mind, it's a coin flip. If you already have an account with one of the companies, stay there. All you have to do is decide whether you want to invest in a state or national fund (if your state has a high income tax, the answer is state), and whether to choose a fund that emphasizes long-term, intermediate-term or short-term duration.
Sometimes mutual fund investing is hard, and sometimes it ain't.
Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.
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