in the history of financial products, exchange traded funds (etfs ) are the ones that reached popularity the soonest. since they were created about 15 years ago, etfs now have $450 billion in assets.

like a mutual fund, an etf offers diversification in one package. unlike a mutual fund, an etf trades all day on a stock exchange — as if it were a share of stock.

the original batch of etfs were like mutual funds. in that they represented a diversified portfolio of stocks. unlike mutual funds, the etfs do not actually buy and sell shares of stock. instead, etf shares are created by swapping new paper shares for baskets of stocks. thus etfs do not have to pay out capital gains like mutual funds and tend to be lower cost and tax efficient.

therefore, traditional stock-based etfs are a great trading and investment vehicle.

however, investors might want to think twice about the new-fangled exotic etfs that are now hitting the market. these new etfs tend to either represent leveraged stock indexes or physical commodities.these etfs suffer from a narrow focus, high leverage, misleading labeling, and tax in efficiency:

1. narrow focus — as an example, the united states oil fund is supposed to track the west texas intermediate crude oil futures market. but it under performs the market due to slippage, since it is a very thin market.

2. high leverage — the etfs from proshares trade 2 or 3 times the underlying index (or its reverse). however, these funds replicate 2 or 3 times the daily movement — not the movement over time. as a result, they may not work the way you expect. for example, the ultra oil and gas etf and ultrashort oil and gas etf are supposed to move in opposite directions — but only on a day to day basis. last year, both funds had double digit losses for the year.

3. misleading labeling — the first trust global wind energy etf sells itself as clean-energy. but the pool of wind-energy companies is so small, the fund has to own shares in bp and royal dutch shell to maintain liquidity.

4. tax inefficiency — many metal etfs, like the spdr gold shares and ishares silver trust, are structured as grantor trusts and result in you paying taxes at ordinary income levels — rather than at capital gains rates.

More about Exchange Traded Fund (ETF) Investment Success — Stick to the Basics!