ETF Industry Perspectives Q3 2025: A muni opportunity and the skinny on SMID-cap ETFs

High-grade municipal bond yields are near decade highs, presenting a compelling opportunity for tax-advantaged fixed income exposure due to elevated supply, market volatility, and their insulation from tariff risks, with particular value in intermediate and long durations. Concurrently, while core equity flows heavily favor S&P 500 ETFs, investors are advised to strategically complete their U.S. equity exposure with small- and mid-cap (SMID-cap) ETFs, emphasizing the critical need to avoid index overlap and ensure consistency across index providers to optimize portfolio construction and prevent performance dispersion.

Analysis

The current fixed income landscape presents a notable opportunity in high-grade municipal bonds, where yields are approaching their highest levels in over a decade. This is attributed to a confluence of factors including market volatility, elevated supply, and muted demand. For investors in high tax brackets, the value proposition is particularly compelling, with tax-equivalent yields ranking in the 97th percentile relative to the past decade as of May 31, 2025. The intermediate- and long-dated sections of the curve show particular attractiveness, with municipal-to-Treasury yield ratios of 89% and 91% respectively, before accounting for tax benefits. Defensively, the asset class is largely insulated from tariff risks due to its domestic revenue sources, and its strong credit fundamentals, with almost 75% of outstanding debt rated AA– or higher, offer resilience against a potential economic slowdown. Concurrently, in equities, massive inflows of over $460 billion into the four largest S&P 500 ETFs over the past three years have solidified large-cap core positions for many investors. This trend necessitates a disciplined approach to completing portfolios with small- and mid-cap (SMID-cap) exposure. A key risk highlighted is the potential for significant performance degradation and unintended portfolio tilts resulting from mixing index providers for large-cap and SMID-cap allocations, as evidenced by return differentials as high as 14.8 percentage points on a cumulative five-year basis between different small-cap indexes.

Key Decisions for Investors

• Investors in high tax brackets should evaluate increasing allocations to intermediate- and long-duration municipal bond ETFs to capitalize on tax-equivalent yields that are currently near decade highs.
• Portfolio managers must audit their U.S. equity exposure to ensure SMID-cap allocations are complementary to core large-cap holdings, preferably by using completion indexes or ETFs from the same index family to avoid unintended overlaps and performance deviations.
• Consider municipal bonds not only for their tax advantages but also as a defensive allocation, as the market's strong credit quality, with nearly 75% of debt rated AA- or higher, provides resilience against a potential economic slowdown.