Image: Stock market crash © Image Source, SuperStock

Who doesn't love exchange-traded funds? After all, these popular investment instruments give us easy access to broad collections of stocks, commodities and currencies -- as well as exotic investment strategies that would be tough to set up on our own.

Plus, we can get in and out of ETFs quickly during the trading day, unlike with mutual funds. These conveniences help explain why ETFs have become wildly popular and are seen as a kind of investor's paradise. They also explain why the money invested in ETFs more than tripled over five years to hit $1.3 trillion last year.

But look closely and you'll see why many experts warn of trouble in paradise.

Above all, ETFs are starting to look a little too much like the mortgage-backed securities that blew up the financial markets in 2008-2009. And ETFs may be choking off financing to small companies, which are the lifeblood of innovation, economic growth and job creation.

Plus, many types of ETFs are not what many investors assume them to be, leading to unexpected losses. Some of the funds can blow up your portfolio like a stick of dynamite.

image: Michael Brush

Michael Brush

Let's take a closer look at how dangerous these deceptively innocent -- yet popular -- investment instruments can be.

The risks of triggering a financial meltdown

The biggest risk in ETFs is that they may be setting us up for the next meltdown, experts warn. The reason: Many ETFs have characteristics in common with the home-mortgage-backed instruments of yore -- the ones that got us all into big financial trouble starting about four years ago.

Just as home-mortgage-backed instruments promised a path to a share of the profits in a booming real estate market, ETFs do the same for different assets and investing concepts.

That's because ETF providers are pushing the envelope in a bid to devise ever-more-exotic investment options. Long gone are the days when they could attract money simply by launching a plain-vanilla ETF that tracks a stock index like the Standard & Poor's 500 Index ($INX).

Now they are churning out ETFs that try to replicate the returns of leading hedge fund managers or the performance of the stocks and debt in emerging markets.

But it doesn't stop there. We also have ETFs designed to act like trading instruments on steroids. Known as leveraged ETFs, these funds go up (or down) two or three times as much as the market. Other ETFs serve as plays on interest-rate volatility, inflation or esoteric currency-trading strategies.

In short, the financial wizards are cranking out more types of ETFs, just as they crafted increasingly complex securities based on home mortgages.

Now here's why danger lurks. Unlike a simple Vanguard S&P 500 ETF, these more esoteric instruments represent underlying assets that are hard, or impossible, to buy and sell in the real world. In the case of leveraged ETFs or ETFs that aim to replicate hedge fund returns, there's no underlying asset to purchase.

So ETF providers turn to financial wizardry. They use complex, customized derivatives loaded with debt to create "synthetic" ETFs. Or they hire experts at banks to do it for them. The wizards regularly use swap agreements, in which parties exchange income streams from different assets held by each. And when an ETF provider hires a bank to create synthetic ETFs, it makes the bank post securities as collateral to reduce the "counterparty risk" in the transaction.

If this is starting to sound familiar, it should. We now have ETF investors chasing returns via complex financial instruments backed by leveraged derivatives, swaps and counterparty risk -- many of the elements and risks that sank mortgage-backed securities in 2008 and wiped out investment banks like Lehman Brothers and Bear Stearns, creating the financial crisis we're still recovering from.

Nejat Seyhun, a finance professor at the University of Michigan's Ross School of Business, worries about the similarities. "We started out with simple EFTs. Now they are getting into similarly complex securities that are highly leveraged," he said. "It could pose systemic risk. There's absolutely no doubt about that."

No one, including Seyhun, is arguing this will happen next week. After all, complex financial instruments are used every day by banks, investors and even Warren Buffett. They work just fine as long as the markets are functioning well.

But that's the catch. If the financial markets get stressed -- because of a Greek debt default, say, or another flash crash -- fear could rise to levels that create serious problems for synthetic ETFs.