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.

Many of the derivatives and swaps behind them could sharply decline in value as investors shun risk and demand dries up, making them hard to unwind. Or, collateral that ETF providers expect to use as a backstop to return money to ETF holders could turn out to be worth a lot less than expected.

"More and more ETFs are based on strategies, not assets," says Andrew Lo, a market expert who teaches finance at the Massachusetts Institute of Technology's Sloan School of Management. "During normal times, everything looks just fine," he said. "But strategies can be liquid until they are not, and the unwind risk is tremendous. One counterparty can get in the hole for a large amount and default."

Lo is not saying this threat is imminent, but he said he's concerned about a lack of transparency that makes the strategies hard to assess.

Many esoteric ETFs are being created by players who list them in Europe, Singapore and Hong Kong, where disclosure rules aren't as strict as they are in the United States, said Srichander Ramaswamy, an ETF expert at the Bank for International Settlements, in a recent study on these risks.

The sheer number of players behind synthetic ETFs can make it hard to figure out what's really going on, Ramaswamy added.

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One source of comfort is that the amount of assets in these instruments is relatively small, around $150 billion. But the rapid growth in ETFs is likely to continue because of two forces: Investors love them, and so do the banks cooking up the financial instruments behind synthetic EFTs. Banks like them because they're profitable, and they also offer a convenient way to make money from assets they typically have to hold anyway.

Choking off funding for small companies?

ETFs may also make it harder for small companies to get funding to grow, says Harold Bradley of the Kauffman Foundation. As money flows into ETFs that represent small-company indexes like the Russell 3,000, many ETF managers will buy shares of virtually all the companies in the index. Unlike professional money managers, they don't distinguish between good companies and weaker ones. They just drive up the shares of all.

But this blunts one of the key roles of the stock market, which is to reward superior companies by giving them an advantage in raising capital when they issue new stock. When good and bad companies advance indiscriminately, some money that would have gone to the superior companies goes instead to the weaker ones.

On the other hand, ETFs representing a broad index like the Russell 3,000 often do not buy the smallest of the companies in the index, because trading volume is low. Instead, they use financial tools to compensate for the tracking errors. The upshot is that the shares of some really good, but very small, companies inevitably get left behind, Bradley said. This makes it harder for them to raise the capital they deserve.

Seeing this play out, some small companies decide not to go public. Bradley said fewer initial public offerings among small companies threatens the economy by depriving small companies of the cash they might use to hire workers and grow.

"ETFs are now undermining the traditional price-discovery role of exchanges, discouraging new companies from wanting to be listed on U.S. exchanges," he said in a study called "Choking the Recovery: Why New Growth Companies Aren't Going Public and Unrecognized Risks of Future Market Disruptions."

ETF risks and your portfolio

ETFs can also do some serious damage to portfolios, especially the leveraged ETFs that can rise or fall two or three times as much as the overall market. "Leverage ETFs are like a stick of dynamite that can, and often do, blow up," said Andrew Stoltmann, a Chicago attorney who represents investors who have lost from $50,000 to $500,000 using leveraged ETFs.

Stoltmann cautions investors to limit leveraged ETF exposure to less than 5% of the overall portfolio size, and to "be prepared for potentially very large losses."

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Leveraged ETFs are best used to hedge portfolios, or to place very short-term bets on one- or two-day moves in an index, said Brian Ullmann of Ford Financial Group in Fresno, Calif.

ETFs using derivatives to replicate the performance of an underlying asset pose another risk to your portfolio. Since they use derivatives instead of buying the actual commodity, they can miss big in trying to replicate the moves of that asset. This happens more often than you might think with commodity ETFs.

"Sometimes what is advertised is not what you get," cautioned Michael Perelstein, a professor at Columbia University who also has extensive experience managing money. "You end up winning on the idea but you feel like a loser," he says. "For an investor, that is frustrating."

Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.