The exchange-traded-fund industry has gained popularity the last five years by trumpeting the advantages ETFs have over traditional mutual funds, including tax efficiency and lower costs. Those are some of the main reasons ETFs now hold almost $600 billion in assets, a fourfold increase from the tally in 2003.

But the credit crisis that has brought Wall Street to its knees has also had a profound impact on ETFs and called into question one of their additional calling cards: trading flexibility. When the SEC temporarily banned short-selling of hundreds of stocks, mostly in the financial-services sector, it sent a ripple through the ETF world. Regular ETFs can be shorted, and a niche within the industry, so-called short/leveraged funds, have become popular options for sophisticated traders. Both small and large investors were left to wonder if they would still be able to pull off short trades.

The answer is yes. Traders can still short regular ETFs and purchase the leveraged/short ETFs -- at least for now, anyway. The brokerages and fund families we talked to reported as much. But as one brokerage spokesperson put it, the situation with the SEC is constantly "evolving." Indeed, the SEC tweaked its rules as recently as Monday.

Short-sellers don't exactly have the best reputations. They borrow shares of a given firm in hopes that the share price will fall and they can replace what they borrowed with shares at the cheaper price. The short-seller pockets the difference between the price he borrowed at and the new lower price. As Wall Street chief executives like Morgan Stanley (MS) John Mack were frantically trying to find ways to keep their doors open, they complained short-sellers were unfairly preying on their stocks, especially so-called "naked" short-sellers. Naked short-sellers don't actually borrow the shares. The SEC tried to put a stop to some of these unscrupulous trades with its temporary measure, which will last into October and may be extended past the election season.

The ban targeted specific companies without expressly mentioning ETFs, which left a cloud of uncertainty. ETF shares are created by a transaction between the ETF sponsor and a so-called authorized participant, usually a big financial institution like UBS (UBS) . The authorized participant will buy the companies in a given index and exchange them for ETF shares. When an investor decides to short a regular (or long) ETF, say the iShares Dow Jones U.S. Broker-Dealers (IAI), a fund that tracks an index of companies like Merrill Lynch (MER), Goldman Sachs (GS) and Morgan Stanley, the underlying transaction doesn't involve borrowing any shares. The investor is simply betting the ETF and its basket of stocks will fall in value. So, according to ETF sponsors and firms like Scottrade, Charles Schwab (SCHW) and TD Ameritrade (AMTD), these trades can still be performed. However, liquidity could become an issue. If the controversy heats up we could see some counterparties refusing to participate in these trades.

The ban had a bigger impact on leveraged and short ETFs sponsored by companies like ProShares and Rydex. These companies construct their funds just like regular ETFs, but they use futures, swaps, options or other derivatives instead of individual company shares. (At some point the companies issuing the futures will have to short stocks, but for now it seems like there is a gray area as to whether that violates the SEC's ban.) Some of the ETFs try to produce double the long or inverse returns of their benchmarks, designated by an "ultra" or "2x" in their names. These funds, which investors use to make very short bets on the direction of the market, have been one of the most popular niches in the industry. According to Morgan Stanley, 78 ETFs in the leveraged/short category hold $21 billion.

On Friday, a day after the SEC ban was announced, ProShares said it was no longer issuing new shares of its Short Financials (SEF) and UltraShort Financials (SKF) ETFs. "We thought there was the potential for extraordinary demand to create new shares" given investors couldn't short individual financial firms any longer, says ProShares founder Michael Sapir. He was also concerned his firm wouldn't be able to get sufficient short investment exposure through its counterparties to cover any new shares. The funds still trade but the company hasn't resumed creating new shares. A similar situation played out at Rydex.

While trading continues, Morgan Stanley analyst Paul Mazzilli thinks the ban on short-selling will lead to greater tracking error. Tracking error is the difference between the net asset value return of the ETF and that of its benchmark. "The ban on short-selling has increased the costs and complexities of maintaining the ETFs' desired exposure, which should lead to higher NAV tracking error," Mazzilli wrote in his latest research note. He also thinks the ban could lead to the ultra ETFs trading at a premium or discount to their net asset values.

Of course, these funds are a tiny part of the ETF marketplace. But their troubles do show how investors can get burned -- very quickly. Best to check with your broker before buying any of them.