Can a passive index fund accurately track its index when it has only one holding for every 423 holdings of the underlying index? Last week (4/14/11), State Street Global Advisors introduced the SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB). Its objective is to track the S&P Municipal Yield Index, which is designed to measure the performance of “high yield” municipal bonds issued by US states and territories or local governments or agencies. Interest on the securities is exempt from federal income tax, but it may be subject to the alternative minimum tax and to state and local income taxes.

Earlier this month, I described the newly launched SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) as effectively being an actively-managed ETF because of the extreme sampling employed. CBND contains only 7% of the underlying index holdings – one fund holding for every fifteen index holdings.

Now, along comes HYMB that leverages this approach by an order of magnitude – sampling on steroids. It holds only 50 of the 21,149 index holdings. Just 0.2% of the index, or one holding for every 423 index holdings.

How the SEC can allow this to be classified as a passively managed index fund is beyond me. Perhaps the lines are blurring between what the SEC sees as passive versus actively-managed ETFs. Or perhaps the SEC was just asleep at the wheel when this one came through the paper mill.

The Index

The S&P Municipal Yield Index has 21,149 holdings, a modified option-adjusted duration of 8.7 years, and an average yield to worst of 7.2%. State representation is California 15.3%, New York 11.2%, Florida 7.2%, Texas 6.3%, New Jersey 5.3%, and Illinois 4.3%. Sector information is not provided, but the two largest index holdings are tobacco settlement bonds.

The Fund

The fund has only 50 holdings, no yield information, no modified duration data, and no sampling criteria identified. State representation looks nothing like that of the index, with California at 10.6%, N/A (find that on the map) 10.0%, Texas 9.1%, Florida 7.4%, Illinois 5.8%, and New York 5.7%. The expense ratio is capped at 0.45%.

The Conclusion

We know very little about this fund. We do know it invests in municipal junk bonds, but we are left clueless about how it selects its 50 holdings from a universe of more than 21,000. Diversification is a prime ingredient for most junk bond funds, as it mitigates the impact of default risk. A default could potentially be 423 times more devastating for HYMB than for the index.

The HYMB summary page provides a link to Nuveen’s Perspective on High Yield Municipal Bonds (pdf). The document describes how sector exposure is a major driver of performance. However, as noted above, sector allocations for the fund are not supplied. Perhaps even more perplexing is that all index references in the Nuveen document are to the Barclays High Yield Municipal Bond Index while this fund, which carries the Nuveen name, is based on an S&P index.

HYMB may turn out to be a good way to access this market segment, only time will tell. In the meantime, you might want to consider the Market Vectors High-Yield Municipal Index ETF (HYD), which launched two years ago. Its summary page shows a current distribution yield of 6.2% and sector breakdown information.

Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.