JOHN BONORA STARTED USING EXCHANGE-TRADED FUNDS IN EARLY 2009 as a way to jump back into the rallying stock market. And at first, he made a killing. He bought ETFs that followed the financial and technology sectors, and they performed exactly as he d hoped. When the bank and software stocks held by the ETF went up, so did the ETF s price.

Bonora, a 31-year-old banker, presumed he d get the same result when he bought an oil-sector ETF. But even though it was called an oil fund, it worked a little differently than he expected it to. To invest in the sector, the fund relied on contracts called futures; it didn t own any oil or even any oil companies. And when the price of oil rose by 40 percent, the fund gained only about half that, much to the surprise and disappointment of Bonora. It was a learning experience, he says.

Essentially bundles of stocks, bonds or other investments that trade as if they were a single stock, the cheap-to-buy ETFs have become a handy way to diversify into several sectors a standard defense against a wobbly Dow and investors and planners have eagerly embraced them. In all, more than $900 billion is invested in this hybrid product, and that number is growing at a rate of $1.5 billion a week. Indeed, the contrast with mutual funds, the much larger staple of American investing, couldn t be greater: Assets in stock funds have been steadily declining.

But while ETFs have helped keep many investors in the market, the more arcane, niche-oriented products being introduced of late and there are now more than 1,000 funds from which to pick have created a host of potential booby traps that even many pros didn t anticipate. To the surprise of many investors, ETFs have begun to close at a rapid rate, with about 140 shutting down since the beginning of 2008 that s roughly the equivalent of 900 traditional funds closing. (By comparison, only 10 ETFs closed in the previous 15 years.) At the same time, studies suggest that many ETFs are having trouble keeping up with their main promise to investors: to stay as close as possible to, or track, the index they re supposed to follow, whether it s oil, gold or a breed of companies. Indeed, poking into their methodology can be like learning how sausage gets made; many funds don t invest the way most investors expect. Critics say that in a few worst-case scenarios, ETFs performance has been exactly the opposite of what their marketing would suggest.

To be sure, most of these ETF traps are creating more investor headaches than actual losses. If you re counting on the products to diversify your portfolio, for example, it s a hassle when they close or don t work right. But other problems are more serious. Some of the widely touted tax benefits of the funds can disappear, with some fund problems even creating higher tax bills. And so-called leveraged ETFs, products intended for day traders, have left some longer-term investors to walk off with serious losses. Investors need to be careful about understanding what backs up the products, says Scott Malpass, Notre Dame University s chief investment officer, who uses ETFs in the school s endowment fund.

Many of the newest ETFs look radically different from the original concept, as introduced in the early 1990s. The first ETF was designed by State Street Global Advisors to track nothing more exotic than Standard & Poor s 500-stock index. Today, with so many more options, investors can use ETFs to gain access to the far corners of the global economy, tracking everything from Asian dividend stocks to corn. And they do their job so cheaply that brokers and fund managers increasingly see them as a real threat to stocks and funds, which usually cost more to manage. Indeed, many financial-services firms have recently slashed trading commissions on ETFs as they try to capitalize on the phenomenon.

Still, critics and even some fans worry that in the rush to anoint ETFs as the greatest financial innovation in years, investors may be overlooking their drawbacks. George Sisti, a financial planner in Woodinville, Wash., says he recommends all his clients invest in ETFs to play the stock and bond markets. But, he says, he directs them only to broad-based ETFs; many of the newer, more narrowly focused funds, he says, are speculation in disguise. Industry experts say there are three often hidden risks in particular that many investors are unaware of.

VANISHING FUNDS

A couple of years ago, buying European cap-and-trade emissions credits sounded like a great investment idea. The AirShares EU Carbon Allowances fund was launched in December 2008, with $5 million in assets and expectations of becoming a much bigger player. But investors never jumped on board, and it was taken off the market eight months later. DeutscheBank, which now owns the company that made AirShares, declined to comment, but analysts say such closures are often a matter of simple business math. Each ETF s sponsor needs a certain amount of assets typically, at least $50 million to generate enough fees to make a profit. After a while, if investors don t take to it, the sponsor shuts it down. Indeed, almost all of the exchange-traded products that have closed in recent years had much less than $50 million in assets and a few had less than $1 million. Today more than 40 percent of ETFs fall below the $50 million threshold. Three hundred ETFs could close tomorrow, and not many investors would care, says Paul Justice, an ETF strategist at Morningstar.

When an ETF closes, investors don t lose their money; the fund pays them the value of their shares. But that doesn t mean there s no cost. Many investors use ETFs to diversify their portfolio; losing one means paying new commissions and fees for a new investment. And if the ETF has performed well, investors are likely to owe capital gains tax on any shares worth more than they initially paid. That s particularly galling, say advisers, because ETFs are marketed as being tax-efficient and as a result, many investors own them in taxable accounts.

Even veteran investors say they ve been stung by closures. Financial planner Kevin Reardon put a six-figure chunk of his clients cash into an intriguing tech ETF. The Brookfield, Wis., planner liked the fund because it was equal-weighted, meaning it was less likely than other types of ETFs to be hurt by the bad performance of a single big stock. But that structure didn t make the fund popular; the ETF had less than $10 million in assets when it folded in 2009. When Reardon got a notice that the fund was closing, he quickly and embarrassingly reallocated his clients money to another ETF, running up trading costs. These days, Reardon says, he wants to see at least $100 million in an ETF before he invests: What I ve learned is not to be early.

MISSING THEIR TARGETS

After Bonora s oil fund went awry, he sold it in disgust. But as it turns out, his experience isn t at all unusual. Hundreds of ETFs perform differently than the indexes or products they track, sometimes strikingly so. Last year the PowerShares FTSE RAFI Emerging Markets Portfolio rose 67 percent. That s a terrific return, but also a disappointment, considering that the basket of stocks it tracks rose 78 percent a hefty $1,100 difference on a $10,000 investment. (PowerShares declined to comment.)

Industry experts say that discrepancies like this, known as tracking error, are common in many funds that follow indexes. But the problem is particularly acute in ETFs and it s been growing. In 2009, ETFs performance varied from their indexes by an average of 1.25 percentage points, according to a study by Morgan Stanley Smith Barney nearly double the difference in 2008. Dominic Maister, Morgan Stanley s director of ETF research, blames the jump on the explosion of ETFs that follow obscure categories. For example, some investment categories such as foreign stocks or junk bonds tend to be more prone to tracking error, in part because they are more expensive and difficult to trade.

ETFs that trade commodities including, yes, oil run into a similar problem. Most funds can t actually buy and sell commodities themselves, since they d also need grain silos, tankers or warehouses to store them. Instead, they buy contracts based on the commodities expected prices and those contracts prices can vary widely from the commodities actual prices. For now, analysts say, that s the kind of complication that ETF investors have to accept: They can dodge the expense of owning exotic investments but not the potential for unpredictable price moves.

LEVERAGE AND LOSSES

Hedge funds frequently use leverage, or borrowed money, to double or triple their bets, and leveraged ETFs let ordinary investors in on the action. Like other ETFs, they trade like stocks. But instead of holding garden-variety investments, their portfolios are packed with the sort of arcane securities that banks hire math Ph.D.s to invent. The result: products like ProShares Ultra Financials, which says its goal is to double the daily return of an index of financial stocks in either direction. If that index rises 5 percent in a day, the value of an investor s shares goes up 10 percent. Of course, it works the other way, too: If the index goes down 5 percent in a day, the shares would drop by 10 percent.

Obviously, those wide day-to-day swings make the leveraged ETFs unusually volatile and high-risk. And while some very active traders have used them to make a short-term killing, investors who hold on longer can take a beating.

Remarkably, all 52 of the leveraged ETFs that have been operating since Jan. 1, 2008, have lost money during that stretch, according to Morningstar, even those where the underlying index has risen over the same time frame.

These products have created controversy since their debut, and some money-losing investors have sued companies that sell them. If some investors are confused, it may be understandable at times, the industry has been less than clear about what kinds of results they can expect. But recently, many fund companies have taken a more cautionary stance. ProShares declined to comment about the performance of Ultra Financials, but it has added more explicit language in the prospectuses of its leveraged ETFs, saying they are riskier than nonleveraged funds and should be used only by knowledgeable investors. And the Financial Industry Regulatory Authority, the industry-funded group that oversees financial advisers, issued a warning about the funds last year. John Gannon, Finra s senior vice president for investor education, now says the funds are meant typically for day traders.