17. To Muni or not to Muni

I'm having a hard time deciding if a portion of my portfolio should be allocated to Municipal bonds. These bonds, issued by state governments and agencies are free from federal tax. If you buy bonds from your own state (Massachusetts, in my case), they're free from state tax as well (this is a pretty small peanut though; assuming 5% state tax and 5% annual growth, the state tax saving amounts to 0.25% annual gain.) If you're an AMT casualty, you should also make sure that the fund you choose avoids any AMT liability.

Once you do all that, you can get a fund whose income is tax free - about a 40% gain compared to treasuries. For example, a 3% annual yield in tax-free municipal bonds is equivalent to a 5% yield in treasury (or corporate) bonds.

Sounds simple, but of course it's not, for the following reasons:

• Lenders know that the yield is not taxed, and therefore offer lower interest
• It might be difficult to find a fund specific to your state, and even if you do, this will limit your diversification (bonds from one state instead of bonds from possibly all 50 states). Is it worth the extra 0.25% in annual yield? 
• Long-term muni bonds seem to have had (historically) a slight edge over intermediate-term bonds, but they carry higher risk. Are they worth the extra 0.2-0.3% in annual yield?
• Fees for muni bonds can be high: from 0.27% to 0.50% annually, and Vanguard funds have an additional $75 purchase fee (unless you have your account with them.)
• There are way too many options to choose from, and none of them is passively managed, meaning that none of them tracks the Barclays Municipal Bonds index. Coincidently or not, this also means that all of the funds I checked lag behind the index they track. 

The funny thing is that once you compare the returns of all these different options, they end up being about the same!

I focused on 5 funds: FTABX (Fidelity tax-free), FDMMX (Fidelity MA Municipal), FLTMX (Fidelity intermediate Municipal), VWLTX (Vanguard long-term tax exempt) and VMATX (Vanguard tax-exempt MA). If we forget for a second the state tax advantage of FDMMX and VMATX, looking over 10 years there's not much difference between them.

So what should I choose? FTABX since it had the best performance? VMATX since it's exempt from state taxes and has the lowest expense rate? FDMMX since it's also exempt from state taxes, but unlike the former fund has no transaction fee? FLTMX since it focuses on intermediate-term bonds, which should deliver lower volatility? Or VWLTX? Or VWUIR? Or... 

Or perhaps it doesn't matter, at the end of the day. The differences are small, and the ability of past-performance to predict the future is even smaller. I think I'll choose FTABX, because it has the lowest turnover ratio and it looks nice on the chart. Check with me again in 10 years to see if I could have made 0.375% more!