Muni ETFs Capture Billions as Tax-Loss Harvesting Grows

(Bloomberg) — Tax-loss harvesting has turbocharged the growth of municipal-bond exchange traded funds in 2026 at the expense of open-end mutual funds, which may lose much of those assets for good, according to Vanguard Group.

The technique — selling securities that tumbled in value to offset capital gains in other holdings—boosted muni ETF assets by $23 billion in the third quarter, according to data compiled by Bloomberg. At the same time, open-end muni mutual funds had net outflows of $5.3 billion.

To offset gains under tax rules, investors have to swap into a similar, but not substantially identical security, for 30 days.

Investors who moved into ETFs to harvest losses in open-end funds are unlikely to sell and reinvest, said Justin Schwartz, head of municipals at Vanguard. The Bloomberg Municipal Bond Index dropped to its lowest in 14 months on Sept. 29. Since then, returns have climbed almost 6%.

“Are you going to take a gain to get back into the open-end fund?” Schwartz said. “Some of it will find its way back, but there’s a good chance that a lot of it stays in the ETFs at this point.”

Munis dropped about 6.4% in the third quarter, the biggest quarterly loss in more than four decades, as a glut of municipal supply, weak seasonal reinvestment and tax-loss selling collided with rising Treasury yields. Even as the muni market rebounded in October and gained 3.85%, tax loss harvesting continued, according to JPMorgan Chase & Co.

Muni ETFs took in $20.8 billion in October, marking the largest inflow month ever, while their open-end fund counterparts lost $20.5 billion, the largest outflow month since April 2022, JPMorgan said in a Nov. 9 note, citing LSEG Lipper data.

ETFs account for 97% of the $76 billion in muni fund inflows this year, JPMorgan said.

BlackRock Inc’s iShares National Muni Bond ETF and Vanguard’s Tax-Exempt Bond ETF, the two-largest muni exchange traded funds, have taken in $14 billion and $12 billion respectively this year, according to data compiled by Bloomberg. Both funds track broad municipal bond indexes. About 70% of the roughly $266 billion muni ETF assets are in passive funds.

Continued adoption of model portfolios by investment advisers and their clients may also contribute to muni ETF growth, according to Matthew Gastall, head of municipal research and strategy at Bloomberg Intelligence.

Model portfolios, purchased in coordination with investment platforms, package ETFs and other funds into customized asset allocation strategies. Some positions are then tailored to individual risk tolerances, market outlooks and planning objectives, he said.

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