Fast Forward

Investors expecting fee wars similar to those that have erupted among index ETFs are likely to be disappointed, since sponsors who also have mutual funds have little incentive to cannibalize one part of their business by offering significantly lower internal expenses for another. “In terms of fees, this isn’t going to be a race to the bottom, and these aren’t going to be loss leaders,” says Donahue.

Instead, expense ratios for actively managed ETFs will likely come in somewhere between lower-priced indexed products and higher-cost actively managed mutual funds, although Donahue believes it will probably be closer to the latter. But it’s possible that higher trading costs, such as bid-ask spreads and commissions, could narrow or eliminate any cost advantage the new ETFs might have over actively managed mutual funds.

On the plus side, the ETFs would not experience the “cash drag” of mutual funds, which often keep 3% to 10% of assets in cash equivalents to meet redemptions. Even though that money isn’t really being “managed,” investors still pay a management fee on it anyway. And in rising markets, cash can put a drag on portfolio returns.

According to a study published in the Journal of Indexes by William O’Rielly and Michael Preisano, mutual funds maintained an average cash balance of 6.75% of assets over a 10-year period in the 1990s, and the resulting drag from those positions averaged 83 basis points a year. In five of those 10 years, the cash drag stripped more than 1 percentage point from the returns. Of course, in down markets cash can work to a fund’s advantage, and many financial advisors already take it into account when crafting asset allocation plans.

Tax efficiency is another way the new ETFs have the potential to shine. Because of the ETF structure, actively managed ETFs will likely be more tax efficient than comparable mutual funds, although less so than index funds. But it’s still unclear at this point how robust those advantages will actually turn out to be, or how they will compare with the advantages of actively managed mutual funds, which already employ tax-conscious strategies such as low turnover or prudent loss harvesting.

Nonetheless, despite some open questions, sponsors believe it’s possible that the next chapter for exchange-traded funds could be active management. But given the uncertainty surrounding who will buy these ETFs and whether their anticipated advantages over mutual funds will actually materialize, that chapter could take a while to write.