As always in life, there may be unintended consequences to otherwise well-intended actions. This axiom has been proved again and again in the financial industry. Use of the new Leveraged and Inverse ETFs has resulted in blow-ups in trading on the S&P and in negative impacts on investment portfolios. What are these new Exotics and how are they different than a typically ETF?An ETF is an abbreviation for Exchange Traded Fund. Most often, ETFs are designed to follow the performance of an index such at the S&P or MSCI World Indexes. The initial offerings in the early 1990s, the number and types of ETFs have mushroomed. The largest creator of ETFs is now Blackrock, after they acquired the business from Barclays. These ETFs are marketed under the name of iShares and listed on www.iShares.com. There are 400 offered by Blackrock alone and thousands within the financial industry as a whole. The Blackrock ETFs total approximately $500 billion in assets under management.If a fund tracking the basic indexes is not enough, they can be narrowed to a style or industry within the index. Examples include the iShares Russell 1000 Growth Index (IWF) or the iShares MSCI ex US Energy Sector Index Fund (AXEN). They have an associated trading symbol listed in brackets, used to place an order to buy or sell with a broker. There are no sales loads, as per a typical fund. And the overall management expenses are a fraction of a typical mutual fund. However, the dogs on the index come with the well-managed companies. None-the-less, the ETFs are intended to replicate the performance of the index.It is debatable how well the ETFs actually track its intended target. It will depend on how large is the fund in terms of investable assets and the overall size of the index it is tracking. The dynamics of the market change the percentage that a company's stock represents in an index. The managers of the ETFs have to buy and sell the underlying company shares, to keep the ETF holdings in line with that of the market. The ability to make these changes and the associated trading costs are part of its ‘liquidity'. That is a function of how many shares of the companies in the index are available to the public and how often someone is willing to buy or sell them. Not all things are created equal. As the ETFs become more and more specific, the liquidity dwindles and the costs of trading to track the index increase. Many funds ‘rebalance'monthly to the index holdings. That is part of the management of the ETF. There is another level of liquidity, which is the ability of the investor to buy or sell the ETF. The larger more generic ETFs have a higher trading volume and less difference between the so called “bid and ask” spread. That is an implicit cost of trading ETFs that frequently goes unnoticed.With the newer Exotic ETFs, the game plan is more complex. First, there is only an estimated $30 billion invested in the whole group. Hence, the liquidity is thin. Second, they are intended to be shorter-term more speculative instruments. They are rebalanced daily in many cases. This causes a gap between the index and the expected long-term returns of the associated ETF. In a study by Cheng, Minder, and Ananth in the Journal of Investment Management, the authors note that the more volatility in the market and the longer the time frame, the more the Exotic ETF will underperform the index. The larger the size of ETF in terms of money under management, “there is a potential for serious market impacts” similar to the 1987 market crash from programmed trading. To avoid the problems with daily rebalancing, there are a number of new market offerings. These include longer-term Exchange Traded Notes (ETN) and the monthly rebalanced Direxion ETFs.There are other and perhaps better approaches to achieving the effects intended by the Exotic ETFs. The Inverse and Leverage ETFs are designed either to hedge a position by moving in the opposite direction or, in the case of Leverage, magnify the actual returns by two or more times. The alternative approaches better control the impact of the volatility factor that distorts the performance of the Exotics. According to an article in the recent Journal of Financial Planning by Bradley Barnhorst and Christopher Cocozza of DeSales University in Pennsylvania, Futures and Options contracts in addition to ETNs could be considered. Futures contracts can be bought that will track ‘much closer than a Leveraged or Inverse ETF' note the authors.They suggest using E-mini Futures contracts available for the major indexes. To create an Inverse relationship ‘buy a short'. To create Leverage, buy multiple long contracts. These contracts will need to be monitored to avoid losses if the markets move against the contracts. Index Options can achieve a similar result to Exotic ETFs whilst limiting the downside risk. Purchasing a Put will create an Inverse affect that is scaled to the investor's specific requirements. A Call Option will provide upside Leveraged gains. The impact of the Options is correctly magnified as market volatility increases, which is not the case with Exotics. However, the volatility impact can be neutralised if so desired.Like the Exotic ETFs, Futures and Options are not intended for the general investing public. The talents of a trained and experience investment professional should be sought. The Inverse and Leverage ETFs are being offered to retail investors. Using them may not achieve the desired results. The whole universe of ETFs has become very elaborate and has lost its initial benefit of tracking the performance of an index at a low cost. The further from the basics that an investor ventures, the higher the possible unintended consequences to their portfolio.* * *With reference to my column in last Saturday's newspaper, I'd like to add that just increasing money supply has not worked. In fact, more needs to be done. The last line was meant to read: “To avoid hitting a wall of inflation, we need a steady flow from excess reserves for a gentle rise in inflation.”Patrice Horner holds an MBA in Finance, a FINRA Series 7 Licence, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any products. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.