Editor’s Note: This article originally appeared in the March 4, 2011, issue of Personal Finance.

After enjoying generations as the investment vehicle of the masses, mutual funds will face serious competition for assets when a new variant of exchange-traded fund (ETF) hits the market. 

The May 6, 2010, “flash crash” roiled markets and prompted the Securities and Exchange Commission (SEC) and other regulators to examine how fund managers use futures and other derivatives. This inquiry delayed the launch of a number of ETFs, many of which would have been actively managed.

Most observers expect the SEC and its cohorts to wrap up their investigation within the next few months. The final verdict is unlikely to impose meaningful restrictions on fund managers’ trading activities–a relief for both the ETF and mutual fund industries.

Regulators’ recent fact-finding mission temporarily slowed the ETF industry’s rapid expansion, but two long-standing obstacles have prevented ETFs from supplanting mutual funds in investors’ portfolios: traditional retirement plans and a lack of actively managed offerings.

According to the Investment Company Institute, mutual funds contained more than half of US retirement savings in 2009. The investing public’s bias toward mutual funds stems from the prevalence of defined-benefit pension plans. As employers moved to control costs and employees assumed responsibility for planning their retirement, 401(k) accounts and other defined-contribution options became the retirement plan of choice. Until recently, few 401(k) accounts offered access to ETFs.

But that’s changing. As a means of reducing costs to both employers and employees, ING Direct’s Sharebuilder unit began offering ETF-only 401(k) plans in 2005. Last month Charles Schwab announced that it would begin offering ETF-only 401(k) plans sometime next year.

ETF-only plans have gathered assets gradually, likely because the predominance of index-based funds has inhibited inflows. With passively managed funds, investors have little chance to outperform the broader market, save by a favorable allocation to specific security classes, sectors or markets.

This trend is also shifting. At the end of February, investors could choose from 33 ETFs offering some form of active management, with the vast majority following a “smart-indexing” strategy that uses qualitative or quantitative criteria to construct a portfolio. Most of these funds focus on bond and currency markets.

Only AdvisorShares Active Bear (NYSE: HDGE) relies on the management team’s day-to-day investment decisions to pursue its objectives. The fund follows a short-only equity strategy and, not surprisingly, features the highest expense ratio in the ETF universe.

Why aren’t more actively managed ETFs on the market? Most managers hesitate to commit to the level of transparency that the structure requires, fearing that front-runners will make it difficult for them to scale into positions.

As an ETF’s portfolio holdings are updated on a daily basis, other traders would know what names managers are adding, allowing traders to take positions in stocks and then sell into the buying activity. Though not illegal, such activity would diminish the ETF’s returns. For these reasons, the majority of smart-index funds focus on bonds and currencies, markets where front-running is more difficult.

But the SEC’s EDGAR lists dozens of applications to launch actively managed ETFs, suggesting that asset management firms have somehow addressed these concerns. Precisely how fund companies have overcome this obstacle isn’t clear from the regulatory filings–perhaps they’ve simply come to terms with these challenges–but asset managers are clearly eager to enter the space.

When the next generation of actively managed ETFs hits the market, traditional mutual funds will have to fight harder for new assets. One mutual fund firm, Huntington Asset Advisors, has recognized the writing on the wall and asked for the SEC’s blessing to convert at least one of its mutual funds into an actively managed ETF.

That’s because many actively managed ETFs will still be cheaper than their mutual fund cousins. ETFs trade on exchanges, so fund companies are spared back-office functions such as keeping track of and communicating with shareholders–responsibilities that shift to the brokers who sell shares. As a result, actively managed ETFs will be able to slash costs by a third to half of those borne by a comparable mutual fund.

Once actively managed ETFs prove their worth, a positive feedback loop will be created. The most attractive ETFs will appear in retirement plans and begin to attract investable assets, encouraging more actively managed ETFs to launch.

As that virtuous cycle takes hold, you don’t have to be an economist to figure out which structure a cost-sensitive investor would favor.

What’s New

Leveraged Credit Suisse 2X Merger Arbitrage Liquid Index ETN (NYSE: CSMB) was the only new exchange-traded product to launch last week. The exchange-traded note (ETN) is essentially a leveraged cone of Credit Suisse Merger Arbitrage Liquid Index ETN (NYSE: CSMA). The ETN will provide two times leverage to an index tracking proposed mergers and acquisition activity, which is rebalanced every five days. The index’s strategy typically goes long the acquisition target and short the acquirer–benefiting when the target company’s share price rises while the stock price of the acquirer declines. Mergers and acquisitions strategies typically produce lower volatility compared to the broader markets and are usually well diversified.

The fund’s leverage will reset on a monthly basis and should produce monthly returns equal to 200 percent of Credit Suisse Merger Arbitrage Liquid Index ETN. If you include leveraged products in your portfolio, that monthly reset should result in less tracking error relative to products that reset daily.

For more information about ETF investing, try a free trial of Global ETF Profits…