Exchange-traded funds may still be relatively unchartered territory to many retail investors, but they are predicted to infiltrate the mass market from the imminent actively managed ETF to the 401(k) marketplace in the coming years.

ETFs are being used in a wider variety of products, from 401(k)s to variable annuities to 529 college savings plans, according to a recent ETF report by Chicago-based marketing and research firm Mintel.

However, product development is a challenge for the ETF industry, since all the major indexes and combinations of indexes have been snapped up, said Herb Blank, president of New York-based QED International Associates.

As a result, mergers and acquisitions among ETF providers may pick up. Another option is to create an alliance to distribute another firm's products. New ETF companies may enter the market with the express purpose of attracting interest to be acquired by a larger firm in the future. WisdomTree Investments, whose assets recently topped $1 billion, may be such a candidate, according to the report.

Consolidation of ETFs may be challenging, however, since all are tied to specific indices and most are highly specialized, said Mike Rosella, chairman of the investment management practice group at Paul Hastings in New York.

One development that could fuel tremendous growth is an actively managed ETF. Every year the industry has been predicting the launch of active ETFs, but they have not come to fruition yet, said Dan Culloton, senior fund analyst at Chicago-based Morningstar.

The major obstacle is that existing products are required to provide a high level of portfolio disclosure, in order to keep prices close to the net-asset-value, Mintel stated. The drawback to actively managed ETFs is divulging proprietary information that limits the ability of an active manager to execute the fund's strategy, since investors could then track the day-to-day movements of the manager and exploit opportunities before the fund manager.

Some companies are still on the fence regarding actively managed ETFs, said Jeff Tjornehoj, a senior analyst at Lipper of New York. A few firms are creating ETFs based on brand new and unknown indices, he said. People are tying to work around the current dilemma of needing SEC approval for an actively managed ETF, he said. Some experts argue that active ETFs are already in the market, such as niche and alternative-weighted funds, Culloton said.

The industry is waiting to see if actively managed ETFs will compete with mutual funds or complement them, Rosella said. ETFs offer better pricing and a low cost structure; however, once they are actively managed, the low cost structure advantage will most likely go away, he commented.

ETFs could also steal some of the limelight in the 401(k) marketplace, but "the mutual fund vice-like grip on the market needs to broken first," Culloton said. However, mutual funds have been scrutinized more and more in recent years due to improved fee awareness and disclosure, prompting plan sponsors to look into other investment options for retirement plans.

But for ETFs to truly take off in the 401(k) marketplace, wholesalers will need to do a better job of championing them, Tjornehoj said. ETFs have a limited distribution and are sold almost exclusively through broker/dealers, registered investment advisers and wirehouses, Mintel noted. As a result, ETFs are still misunderstood by the general public, said Susan Menke, senior financial analyst at Mintel.

Several financial services companies are looking to place ETFs in 401(k) plans, but the numbers remain low. Invest 'n Retire and 401(k) Retirement Solutions are two firms targeting the qualified retirement plan space that are promoting ETF investment options, the report noted.

Incorporating ETFs in 401(k) plans has been a challenge due to recordkeeping and trading issues, Mintel said. Mutual funds allow investors to buy shares without paying brokerage transaction costs, whereas ETF buyers pay brokerage commissions to purchase shares. The typical 401(k) plan contains only one or two index funds, but as plans increasingly embrace index funds, they are likely to include ETFs in the mix, Tjornehoj said. Additionally, fixed income and socially responsible ETFs could prove appealing choices for retirement plans, according to Mintel.

Small businesses may prove a significant growth opportunity for ETFs in retirement plans, since sponsoring a 401(k) plan is more expensive for smaller companies and administering an ETF could reduce those costs.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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