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ANALYSIS-Passive to a point: ETFs stray from index to sell Puerto Rico debt

NEW YORK, July 25 (Reuters) - Puerto Rico's worsening debt crisis is pushing the managers of some municipal junk bond exchange-traded funds to ditch their mandate for passive management. Instead, they are straying far and wide from benchmark indexes as they try to avoid taking a hit on the island's bonds.

At least two passive ETFs, offered by Van Eck Global and State Street Global Advisors (SSgA), already have made moves to cut their exposure to Puerto Rico bonds to avoid being caught with debt that could be impaired or restructured, portfolio managers said.

Puerto Rico's weighting in some indexes, including the Barclays Custom High Yield Composite Index, has surged to nearly 30 percent from less than 5 percent at the start of the year, raising the dangers for funds that try to track one of the benchmarks. That has happened because more of the U.S. territory's debt qualified for inclusion in the indexes after it was slashed to junk by U.S. ratings agencies.

"There comes a point where our fiduciary responsibility to investors outweighs how we may follow an index," said Jim Colby, who oversees the $1.1 billion Market Vectors High Yield Municipal Index ETF for Van Eck Global.

Fears about Puerto Rico's escalating fiscal woes underscore how passively run ETFs use a sampling approach to mimic the performance of an index. They're not obligated to own each of the thousands of constituents there are sometimes in an index, but instead can select the ones they want to track it, according to fund disclosures to investors about their management approach.

Colby said the ETF fund's management team at Van Eck has daily discussions about how to avoid a hammering if Puerto Rico misses a bond payment, for example. The fund had 4.3 percent of its assets in Puerto Rico debt at the end of June.

The fund seeks to replicate the price and yield performance of the Barclays Custom High Yield Composite Index, which tracks the junk municipal bond market with a 75 percent weighting in below-investment grade debt. The ETF is up just 8.6 percent so far this year, lagging the 10.29 percent advance of its benchmark, according to Thomson Reuters data.

PRICES REELING

Puerto Rico's chronic budget deficits have spooked the U.S. municipal bond market, and now fears of a massive restructuring of its debt have sent its bond prices reeling. The Caribbean island recently passed legislation that authorizes restructuring of some of its $73 billion in debt, which could hurt U.S. mutual funds and ETFs, the biggest holders of the bonds.

The government-controlled electric authority PREPA is the most likely candidate to restructure its debt under the new law.

At State Street's $262 million SPDR Nuveen S&P High Yield Municipal Bond ETF, Puerto Rico bonds make up 5.39 percent of the fund, compared to an index exposure of 13 percent. That's a significant decline from the end of June, when Puerto Rico accounted for nearly 8 percent of the fund's net assets, according to fund disclosures.

Dave Mazza, head of research for ETFs at SSgA, the asset management arm of State Street, said the fund tracks the S&P Municipal Yield Index, which has more than 30,000 constituents. But the ETF has chosen Puerto Rico bonds that are backstopped by insurance, showing how passive funds can sidestep risk.

"So even in regard to an index-tracking product, we have the flexibility to implement and move and position the portfolio away from certain areas that may be riskier than others," Mazza said.

Theoretically, he said the fund could have zero exposure to Puerto Rico if deemed to be appropriate and in the best interest of shareholders.

"Some investors presume that it's a very simple, hands off approach, and that's not the case at all," Mazza said.

(Reporting By Tim McLaughlin; Editing by Richard Valdmanis and Martin Howell)