AS THE ENERGY BUSINESS

roared to life over the last three years investment firms rolled out just over two dozen exchange-traded funds tracking the industry. One of the largest, with $1.3 billion in assets, is the

United States Oil fund

Exxon Mobil

Schlumberger

It used to be that evaluating a decent ETF came down to simply pulling back the curtain on its underlying benchmark, usually the S&P 500 or something from Russell. That's not the case any more because ETF firms desperate to distinguish themselves in a crowded marketplace have resorted to designing new products around exotic and unproven indexes. It's a potentially dangerous trend, especially for the ill-informed investor. After all, you can easily get suckered into what's being billed as a sophisticated fund only to find out that it's a poor performer or it charges way too much for a portfolio of stocks you could find cheaper elsewhere.

In other words, what you think you see might not always be what you get with an ETF. PowerShares' China offering, for example, doesn't track a group of foreign firms. Rather, it puts the cash in U.S. companies that do business over there. Then there's the StreetTracks Gold ETF: One share represents just one-tenth of an ounce of gold bullion. And meanwhile the founders of the Claymore/Ocean Tomo Patent ETF think innovation is a key factor in well-performing companies. So instead of tracking an established index this fund mirrors a group of companies with valuable patent holdings. But most of its portfolio, including firms like General Electric and 3M, can also be found in cheaper funds. All that makes ETF investing tricky. "It's a double-edged sword," says Stephen Barnes, who runs his own investment firm in Phoenix. "It gets easier the more choices and trading volume there is. But the other side of that is it also becomes more complicated."

In our story on the All ETF Portfolio click here for the link we outlined how you could use these funds for every part of your investing account. What we mentioned then and what needs to be repeated here is that there are many risks and rewards to investing in ETFs. Yes, they do have added flexibility and tax advantages over some active and passive mutual funds. But if you don't do the research you could wind up with an ETF that's overpriced, highly concentrated or just plain kooky. It's the difference between picking up an ETF that will make you money and one that could implode.

Know What You Are Holding

There's nothing confusing about owning the 500 largest companies on the stock market. But should one really trump the other? S&P 500 critics like Rob Arnott, founder of Research Affiliates, say that the index over-values stocks because it weights them according to market cap stock price times outstanding shares a tactic that can be skewed when some stocks get red hot. His "fundamental" index uses dividends, revenues, cash flow and book value, among other criteria, to reweigh the index. The

Rydex S&P Equal Weight

Those subtle differences are playing out in other parts of the ETF industry, although in some cases they're more magnified. For example, energy has been a stellar sector the last three years. The iShares Dow Jones U.S. Energy ETF has returned a nice 26% since 2004, thanks to top holdings like Exxon, Schlumberger and Marathon Oil. But despite the name, the fund is incredibly concentrated, with 70% of its assets in its top 10 holdings. Indeed, Exxon and Chevron account for 41% of the fund. Why not just buy those two stocks and be done with it? Meanwhile, investors in the Vanguard Energy index mutual fund enjoyed 30% average annual returns during that same time period. It features the same stocks but with much more diversity. Only 40% of its assets are in its top 10 holdings. The better option should be obvious.

Complex or Kooky?

PowerShares is home to some of the most original ETFs on the market. That isn't always a good distinction, though. After all, do you really need an ETF that invests in water, clean energy or nanotech? We doubt it. Most PowerShares products are based on an "Intellidex" run by the American Stock Exchange. The proprietary formula is based on tried and true stock-picking strategies, so while you aren't exactly getting stocks based on a manager's hunches it's pretty close. That brings us around to one of our cardinal investing rules: Buy what you know. If you read through PowerShares' literature and still can't get your head around its Intellidex, then move on.

Getting a clear picture of what you own can be daunting. Healthshares' ETFs narrowly segment the health-care business according to stocks that specialize in the treatment of cancer or infectious diseases, among other niches. The concept sounds like a good idea. After all, health care is a decent business. But the firm's Cardio Devices ETF is a concentrated portfolio of 22 mostly unknown companies. Fifty-five percent of its assets are in the top 10 holdings, including a 10% position in CryoLife, whose stock price has gone on a roller-coaster ride the last two years, starting at $8 then dropping 50% before winding up around $10 a share. You would have to do some research to know if those firms were worthy investments, which flies in the face of why you would buy an index in the first place. Better to let these ETFs get two legs under them before you buy in.

That was also our reaction to a host of other newly launched ETFs. A Pennsylvania firm will start weighting companies based on revenues. The Claymore/Sabrient Stealth ETF tries to find growth companies that are flying under Wall Street's radar screen. Some of the riskier offerings include those surrounding commodities and currencies. Gold ETFs will actually give you exposure, in one-tenth increments, to bullion. The oil ETF doesn't invest in actual crude but rather a series of futures contracts. "When you start slicing and dicing commodities you are entering a whole other realm," says Darin Pope, a money manager with United Atlantic.

Ultimately, we prefer ETFs based on the well-established indexes at families like Standard & Poor's, Russell and Wilshire. Those bogeys have decades of performance track records so it's easy to see how they'll perform in any market condition. That's valuable information.