Using SMAs vs ETFs for Municipal Exposure

The choice between separately managed accounts and ETFs for municipal exposure isn't just about fees. It's about understanding which wrapper structure delivers better after-tax returns for your specific situation. The point is: a lower expense ratio means nothing if you're paying taxes you could have avoided.

The Core Tradeoff (Why This Decision Matters)

Municipal bond SMAs have grown from $778 billion in 2013 to over $2.2 trillion in 2023, with projections reaching $3.6 trillion by 2026 (Cerulli Associates, 2024). That growth isn't driven by marketing. It reflects a structural tax advantage that ETFs cannot replicate.

The mechanism is straightforward: SMAs allow tax-loss harvesting on individual securities, while ETF investors are stuck with the fund's aggregate tax position. When rates rise sharply (as in 2022), SMA holders can sell underwater positions, harvest losses, and reinvest in similar credits. ETF holders watch those embedded losses accrue inside the wrapper, realizing them only when they sell their ETF shares.

The magnitude during the 2022 rate shock:

Source: Parametric Portfolio Associates, 2023.

SMA Advantages (When the Extra Cost Is Worth It)

Direct tax-loss harvesting remains the primary advantage. Every bond in an SMA is owned directly, meaning losses flow through to your tax return immediately. If your marginal rate exceeds 32% and you hold more than $250,000 in municipal bonds, the tax alpha from harvesting typically exceeds the higher SMA fee versus passive ETF exposure.

State-specific customization matters for high-tax-state residents. A California investor (state rate: 13.3%) or New York investor (state + city rate: 12.7%) loses significant value holding out-of-state bonds. SMAs can construct 100% in-state portfolios, while national muni ETFs typically hold only 15-25% in any single state.

The math on state customization:

Setup: New York investor, 37% federal bracket, considering a national muni ETF yielding 3.1% versus a New York SMA yielding 2.85%.

Calculation:

• National ETF (25% NY, 75% out-of-state):

  • NY portion: 3.1% / (1 - 0.4385) = 5.52% TEY
  • Out-of-state portion (taxed at 6.85% state): 3.1% / (1 - 0.37) = 4.92% TEY
  • Blended: 5.07% TEY

• NY SMA (100% in-state):

  • 2.85% / (1 - 0.4385) = 5.07% TEY

Interpretation: Even with a 25 bps lower nominal yield, the all-NY SMA delivers equivalent after-tax income. Add tax-loss harvesting potential, and the SMA wins decisively.

Credit quality control allows avoiding sectors you don't want. If you're bearish on healthcare munis (Moody's reports nursing home defaults accounted for 60% of 2022 municipal missed payments), an SMA manager can exclude the sector entirely. ETFs hold what the index holds.

ETF Advantages (When Simplicity Wins)

Lower minimums make ETFs accessible where SMAs aren't. Most municipal SMAs require $100,000 to $500,000 minimum investments. ETFs start at the price of a single share (often $25-$110). For accounts below $250,000, ETF transaction cost savings typically offset the tax harvesting disadvantage.

Intraday liquidity provides flexibility that individual bonds lack. Municipal ETF bid-ask spreads run under 1 basis point for large funds like MUB or VTEB during normal markets. Compare that to individual bond spreads of $0.25 to $4.00 per $100 par for odd-lot trades (MSRB, 2024).

Lower management fees matter for buy-and-hold investors. Passive municipal ETFs charge 3-7 bps annually versus 25-40 bps for actively managed SMAs. Over a 10-year hold with no tax harvesting opportunities (stable rate environment), that fee difference compounds meaningfully.

The durable lesson: if you're a taxable investor below the $250,000 threshold or in a low-tax state, ETFs usually win on cost. Above that threshold in high-tax states, run the SMA math carefully.

The ETF Premium/Discount Risk (What March 2020 Revealed)

ETFs trade at prices that can diverge from net asset value during stress. Why this matters: municipal ETF discounts reached 576 basis points for MUB during March 2020 (Bloomberg, 2020). Investors who sold during the panic locked in losses beyond the actual decline in underlying bond values.

The mechanics of dislocation:

Forced selling pressure → ETF share price drops faster than NAV → Authorized participants arbitrage slowly → Discount persists for days

For long-term holders, these discounts represent buying opportunities (if you have cash to deploy). For investors who might need liquidity during stress, the discount risk argues for SMA structures where you can sell specific bonds without amplified market impact.

COVID-era performance comparison:

Source: Bloomberg Municipal Bond Index data, 2020.

Capital Gains Distribution Risk (The Hidden ETF Tax)

Even "tax-efficient" muni ETFs can generate capital gains distributions when:

1. Index rebalancing forces selling appreciated bonds
2. Large redemptions require selling (particularly in rising rate environments)
3. Call provisions force realized gains on premium bonds

SMAs avoid this entirely because you control when gains are realized. If you hold until maturity or death (with stepped-up basis), you may never realize embedded gains.

The test: check the ETF's capital gains distribution history before assuming tax efficiency. Some "tax-exempt" muni ETFs distributed taxable capital gains in 2022 when forced selling during outflows created realized gains.

Decision Framework Checklist

Choose SMA When:

1. Account size exceeds $250,000 in municipal allocation
2. Your combined federal + state marginal rate exceeds 35%
3. You live in a high-tax state (CA, NY, NJ, CT, HI)
4. You have strong credit views on sectors to exclude
5. You value control over taxable event timing

Choose ETF When:

1. Account size is below $100,000 in municipal allocation
2. You're in a low-tax or no-income-tax state
3. You prioritize liquidity and trading flexibility
4. You prefer passive, rules-based exposure
5. Your time horizon is long enough to ride out discount episodes

Consider Both When:

1. Core allocation in ETF (liquidity, simplicity)
2. Satellite allocation in SMA (tax harvesting, customization)
3. Rebalance between structures as account size grows

Cost Comparison (Realistic Numbers)

*For investors in high-tax states (CA, NY, NJ).

Source: Nuveen SMA research, 2024; author calculations.

The point is: for high-tax investors with sufficient assets, the SMA "costs more" only if you ignore the tax benefits it delivers. When you include tax alpha, SMAs often have negative effective costs.

Implementation Considerations

SMA manager selection matters more than with ETFs. Look for:

• Dedicated municipal credit analysts (not just quant screens)
• Systematic tax-loss harvesting protocols
• State-specific inventory access
• Transparent reporting on harvested losses

ETF selection for municipal exposure typically comes down to:

• Expense ratio (MUB: 7 bps; VTEB: 5 bps)
• Duration profile (match your rate view)
• State concentration (if you want specific exposure)
• Trading volume (affects bid-ask execution)

The durable lesson: this isn't an either/or decision for larger portfolios. The optimal structure often combines ETF core holdings (for liquidity and low base cost) with SMA satellites (for tax harvesting and state optimization). As your municipal allocation grows past $500,000, shifting more to SMA structures typically improves after-tax outcomes by 20-50 bps annually for high-tax investors.