Essentially bundles of stocks, bonds or other investments that trade as if they were a single stock, 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, $905 billion is invested in this hybrid product, and that number has been growing this year at a rate of $1.5 billion a week. Assets in stock mutual funds, meanwhile, 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 potential booby traps that even many pros didn’t anticipate. To the surprise of many investors, ETFs have been closing 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. Critics say that in a few worst-case scenarios, ETFs’ performance has been exactly the opposite of what their marketing would suggest.

Handle With Care

Exchange-traded funds have attracted more than $900 billion in assets. But some of the newer ETFs have potential drawbacks that can snare the unwary. How to dodge trouble:

• Go Big. Financial-services companies are more likely to close a fund if it hasn’t attracted enough assets to be profitable. Kevin Reardon, a financial planner in Brookfield, Wis. says he prefers to see at least $100 million in an ETF before he invests there.
• Avoid the Niches. In the recent rally, many niche ETFs haven’t kept up with the performance of the assets or indexes that they track. George Sisti, a financial planner in Woodinville, Wash. says he steers his clients only to ETFs that follow broader indexes; many of the more narrowly focused funds, he says, are speculation in disguise.
• Look Out for Leverage. Leveraged ETFs use borrowed money and complex investments like derivatives to try to snare large short-term gains. Many of these funds have lost money over the long run. Industry experts recommend them only for confident traders who keep a close eye on their portfolios day-to-day.

To be sure, most of these ETF traps are creating more 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 as expected. 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.

Industry experts say there are three often-hidden risks in particular that many investors are unaware of.

Vanishing funds: For each ETF, the investment company that sponsors the fund needs a certain amount of assets — typically, at least $50 million — to generate enough fees to make a profit. So if investors don’t take to a fund, the sponsor typically 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% 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, but that doesn’t mean there’s no cost. Shareholders can wind up paying new commissions and fees for a new investment to replace the closed fund. And if the ETF has performed well, investors may owe capital-gains tax on any shares worth more than they initially paid.

Missing their targets: Mr. Bonora’s experience with his oil fund isn’t at all unusual. Hundreds of ETFs perform differently than the indexes or products they track, sometimes strikingly so. Industry experts say that such discrepancies, known as tracking errors, have 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, attributes the jump to the explosion of ETFs that follow obscure investment categories that tend to be expensive and difficult to trade.

Commodity ETFs run into a similar problem. Most funds can’t actually trade commodities themselves, so they buy contracts based on the commodities’ expected prices. And those contracts’ prices can vary widely from actual prices.

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. One typical example: the ProShares Ultra Financials fund, whose advertised goal is to double the daily return of an index of financial stocks — in either direction.

Those wide day-to-day swings make leveraged ETFs unusually volatile and high-risk. Consequently, the companies that make them say they’re best suited for day traders who hold them only briefly. But investors who hold on longer can take a beating.

Remarkably, all 52 leveraged ETFs that have been operating since Jan. 1, 2008, have lost money, according to Morningstar, even those where the underlying index has risen over the same time frame. (Ultra Financials is one such product; ProShares declined to comment on the fund’s performance.)