Courtesy of Michael Pollock, Wall Street Journal

Index funds aren’t always what you think they are. And your innocence could cost you.

To most investors, of course, index funds are passive investments, providing returns that basically mirror the market they are designed to follow. They charge low fees and carry no hidden costs.

But the old definition is starting to change. Unlike simpler, earlier generations of index and exchange-traded funds, new variations are morphing into products that risk putting many investors afoul of the old rule about not investing in things you don’t understand.

As more money flows toward indexing, some fund firms are trying to capture a share of it by creating complex ETFs that blend active management and indexing. The fees charged by some of these funds can be several times those charged by traditional index funds. And, because they sometimes specialize in very narrowly defined, less-active markets, they can wrack up hidden trading costs.

Consider one newer, complex index fund, IQ Hedge Multi-Strategy Tracker, a four-year-old ETF from IndexIQ Advisors LLC that tries to duplicate the returns of hedge-fund investments. For example, when hedge funds go “short” in a certain market, betting that prices will decline, IQ Hedge mimics that activity by taking a short position in an ETF that focuses on that market. Hedge funds follow lots of complex strategies in many different markets, however, and IQ Hedge tries to copy many of them simultaneously.

It requires considerable expertise to know how to use such an index fund effectively in a diversified portfolio. “Investors who aren’t sophisticated in sector rotation and asset allocation might be making a mistake to invest in some of these new, complex products without understanding what’s inside each fund,” says Anthony Hohmann, who oversees ETF analytical products at S&P Capital IQ, a unit of McGraw-Hill Cos.

That doesn’t mean the newer funds aren’t worth looking at. But before you buy, here are some things to consider.

For the balance of the WSJ article, please click here