Billions of dollars have been poured into ETF in recent years. Many investors misunderstood the products and only learned it the hard and expensive way.

Japan earthquake and recent meltdown of silver price have caused various pitfalls of ETF exposed to daylight.  ETF was also scrutinized lately with numerous regulatory warnings and concerns raised by the Financial Stability Board

Think ETF is transparent? If I were to ask you if your ETFs are lent to hedge funds, you will most probably have no clue what I am talking about.

Terry Smith, founder of Fundsmith, wrote a blog recently, ETFs – Worse than I thought, highlighted another danger inherent in the structure of a product that combines features of an open-ended fund with those of a closed-ended product.

The fact that ETFs are tradable on the secondary market, Smith says, means there is a possibility that market participants will short ETFs themselves. The ability of ETFs to create new shares means there is no restriction on the amount of the ETF that can be shorted.

This causes a problem whereby “the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest.  This is a significant problem given reports that there has been short-selling up to levels of 1000% short in some ETFs”.

Thus, retail investors, at whom Smith says ETFs are increasingly being marketed and targeted, may find that money they believe to have been invested in exchange-traded funds have “in effect been lent to hedge funds”.

“The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do.”

While the ETF story is very hot, it is also very spicy.