SAN FRANCISCO (MarketWatch) — Oil-related exchange-traded funds are basking in the glow of a spike in crude prices to their highest levels in two-and-a-half years, but potential investors need to slap on a pair of sunglasses and take a good look at the risks to avoid getting burned.

Overall, the oil market is already well-known in the commodities world for its fast-paced and volatile environment. There’s a lesson to be learned there.

“The price of oil can hinge on a number of factors: the political climate in the Middle East and North Africa, a natural disaster, such as a hurricane or earthquake, or the dollar’s motions in the course of a single day,” said Tom Lydon, president of Global Trends Investments and editor of ETF Trends. “One wrong move and the price of oil can swing by double digits.”

“Playing energy requires knowing what you’re getting into and making sure you’re comfortable with the potential pitfalls,” he said. “You need to have time to monitor what you’re holding and be prepared to act when necessary.”

And that advice certainly comes in handy for those considering investment in oil ETFs.

“While these products arguably allow for a more convenient and cost-effective manner in which to access the oil market, they come with their own set of pros and cons that need to be fully understood before considering an investment in such a product,” said Kevin Mahn, chief investment officer and portfolio manager at SmartTrust Unit Investment Trusts.

ETFs that invest in crude futures have fared well year to date, but not as well as crude futures.

Year to date, the United States Oil Fund USO, +2.13% has scored a gain of 9.2%, PowerShares DB Oil Fund DBO, +2.27% is up 14.3% and the Teucrium Crude Oil Fund CRUD, +1.55% has climbed about 4.9% since its launch in late February. Track ETF performance on Morningstar.

That all compares to a more impressive 16.8% jump in crude futures prices for the same time period. They closed at $106.72 Thursday. Read more on oil futures.

“The devil is in the details with each of the oil-related ETF products currently available in the marketplace,” said Mahn. And “unless investors are well educated on the underlying mechanics of the instruments, they are likely to be surprised by their results.”

Futures bets

Among the steps potential ETF investors can take in an effort to safeguard their investments is deciding whether to pick an ETF that buys oil -- or stocks in oil companies.

“The largest consideration when selecting an oil-related ETF is whether that product is futures based or equity based,” said Christian Magoon, chief executive of consulting firm Magoon Capital.

“Futures-based products have generally not performed in line with investor expectations,” he said. “Investors who are highly educated about oil futures and futures-based ETF nuances should explore this area.”

News Hub: Oil back above $105 per barrel

The ETFs that hold futures are held in the fund and sold as the expiration date approaches — at which point a new futures contract is purchased, according to Lydon. Those include the U.S. Oil Fund, PowerShares DB Oil Fund and Teucrium Crude Oil Fund.

Mahn explained what he referred to as a “tracking error” between the underlying oil market and the ETFs that “purport to track them in some manner,” which have left many advisors and investors bewildered and frustrated.

Understanding that “tracking error” requires an understanding of how the futures market works.

Take the U.S. Oil Fund, for example. “Within the USO portfolio are contracts for crude oil that roll into new contracts for crude oil on a monthly basis,” Mahn explained.

In the futures market, when the price of oil for future delivery is higher than the spot or current price, this would create a situation called contango and under those circumstances, an ETF such as USO “stands to potentially lose value on each successive contract roll.”

But when the price of oil for future delivery is less than the spot price, it creates a situation called backwardation, and in that type of environment, USO would “have the potential to gain value on each successive contract roll,” he said.

“Periods of contango can lead to underperformance related to the underlying commodity, and periods of backwardation can lead to outperformance related to the underlying commodity for oil ETFs that are similar in structure and strategy to USO,” he said.

“Hence, everything isn’t always what it appears to be on the surface,” he said. Read a 2010 story about ‘toxic’ commodity ETFs.

Still, ETFs may be worth the risks.

“It’s increasingly difficult to beat the S&P 500 SPX, +0.82% and … the majority of investors would be better served buying an index fund or ETF which beats 90% of [financial professionals such as stockbrokers and planners] without the worry, hassle nor time wasted trying,” said Scott Barclay, author of How The Investment Business Really Works.

Share bets

There are also ETFs that hold shares of oil exploration and production companies.

“These ETFs are a way to gain exposure to the oil market without the same level of volatility that can be found in futures,” said Lydon.

These include the iShares Dow Jones U.S. Oil & Gas Exploration IEO, -0.75% , he said, disclosing that he has a client who owns the ETF. Other ETFs holdings company shares include the SPDR S&P Oil & Gas Exploration & Production XOP, -0.89% and Vanguard Energy ETF VDE, -0.54% .

“The features of an equity-based oil ETF versus an energy mutual fund would be that the portfolio is transparent and there is liquidity intraday,” said Magoon.

“The transparency allows for an investor to truly know what they own,” he said, which is important when it comes to unexpected events such as the BP BP, -1.18% oil disaster last year. And “the liquidity allows investors to adjust their allocations in the face of the many geopolitical events that affect oil prices.”

And that’s vital for investors navigating the recent events in oil-rich regions. Political instability in the Middle East and North Africa, particularly Libya, have contributed to a spike in crude-oil prices CLK11 to nearly $107 a barrel in New York Thursday. Read more about oil’s Thursday performance.

“Many investors can’t afford to put together a portfolio that diversifies among a variety of individual energy stocks, which leaves them holding too much company-specific risk,” Magoon said. But “an equity-based oil ETF provides a more diversified approach to oil investing with individual names.”

Among these, he said that the SPDR S&P Oil & Gas Exploration & Production ETF provides exposure to energy companies that are seeking out new reserves, which is a growth business. Year to date, XOP gained 22%.

Futures-based ETFs have “generally not performed in line with investor expectations due to issues like contango and backwardation in the futures market,” said Magoon.

But “chart XOP versus USO for any time period … and you will see why investors should focus on ETFs like XOP,” he said. The USO has climbed around 47% in the last two years, while XOP has more than doubled.

The iPath S&P GSCI Crude Oil Total Return Index Exchange-Trade Note OIL, +2.23% is another type of investment vehicle for investors. OIL has climbed 10% year to date.

An ETN doesn’t have any “real” assets, but it’s linked to the total return of a market index, said Paul Dietrich, chief investment officer at Foxhall Capital Management.

“For investors looking for oil as a long-term investment trend, both USO and OIL present a similar exposure to oil markets, but each fund has potential drawbacks and advantages so it’s hard to declare one as universally better than the other,” he said.

He said he recommends buying “equal amounts of each fund for long-term investors looking at oil as a long-term commodity trend — which it is.”

Keeping focused

So given all the hidden intricacies involved in oil-related ETFs, investors should stay focused on their overall goals.

Investing in this market “is a gamble, but oil is quite volatile now, which means there is more of an opportunity to make big bucks, as well as lose big bucks if the trader bets wrong,” said Charles Perry, president of energy-consulting firm Perry Management.

“The best thing the trader can do to be on the winning side is to be intense in his trading and stay on top of all the news,” he said.

And those wary of the latest price rise can be reassured that many experts continue to predict even higher prices for oil in the years to come.

“Prices have risen faster than perhaps they should have done, but more expensive oil always looked necessary — to make the necessary investments that will be required to satisfy [demand],” said Matt Parry, chief economist at KBC Energy Economics.

“So, essentially, we’ve just got tomorrow’s prices today,” he said.