The exchange traded fund has emerged as the rock star of retirement-planning portfolios.

In the past six years, the number of accounts worldwide has increased 345 per cent, bringing total assets to $504.5-billion (U.S.), according to Morgan Stanley's most recent report on the sector. This year, even more ETFs are being created, offering small investors a chance to make bets on an entire market, such as energy. Institutional and hedge fund managers also are piling on to gain exposure to specific markets.

Though ETFs sound complex, they're simple. They are low-fee, passive investments that represent a basket of stocks in a given country, region or sector.

But there is an added feature: units of an ETF trade on an exchange, just like a stock. Some ETFs mirror the performance of broad indexes such as the TSX Composite index or Standard & Poor's 500 index, while others follow such sectors as oil, gold or technology.

"It's transparent - you know what you're getting. So they work very well with putting portfolios together," said Geri James, who heads the iShares Canada unit of Barclays Global Investors, the largest ETF manager in the world with a little under half of total market share by assets. Other ETF providers include Vanguard and Claymore Investments.

What's driving the surge in interest among small investors?

"It's the flexibility, because you get everything that you'd have with a mutual fund plus the extra features of a low cost. That's a big selling point," Ms. James said. Most ETFs charge less than 1 per cent in management expense ratios (MERs), compared with about 2.5 per cent for the average equity mutual fund. ETFs weren't always so popular. In fact, they didn't exist until 17 years ago, when a few Canadians had a fresh idea.

The Toronto Stock Exchange's plan was to create an investment that tracked the performance of the 35 biggest equities by market capitalization in what was then called the TSE 300 Composite index. Called "Toronto Index Participation Units," these securities were quickly dubbed TIPs.

When the TSX 60 index was introduced a decade later, Barclays used it to create its own ETF. A year later, the two products merged.

The first ETF in the United States was created in 1993 by State Street Corp., in partnership with the American Stock Exchange. It was designed to track the value of the S&P 500 Index. As ETFs have multiplied, so too have indexes manufactured for the purpose of building an investment around them, said Richard Croft, president of RN Croft Financial Group and co-author of Protecting Your Nest Egg: A Canadian Guide to Wealth Protection.

"Some of them aren't good quality indexes," Mr. Croft said. Investors should avoid buying ETFs from firms that are planning to "simply create a new index to say, 'Look at the track record!' and going out and building an ETF." But there are benefits to holding an ETF that is based on a solid index, he said.

The low trading fees and turnover mean low MERs. As well, ETFs are always fully invested, unlike regular mutual funds, which must keep some cash on hand for redemptions.

ETFs don't have to hold cash because the units are traded, rather than sold through a broker, Mr. Croft said. "Holding cash is a drag on performance, there's no way around it," said Mr. Croft, who says ETFs give the investor a better chance of getting greater returns in a bull market.

Investors should avoid ETFs linked to sectors that aren't growth industries, Mr. Croft said. In particular, he points to gold, which peaked at more than $800 (U.S.) an ounce in 1980 and sells for about $630 today, and oil, which has not kept pace with inflation over the past quarter-century.

It's better to buy an actively managed equity mutual fund, he said, and use more passive index-tracking investments for growth industries such as financials, he said. In particular, Mr. Croft likes the Barclays Canada iShares S&P/TSX Financial ETF.

The problem for some investors is that they add ETFs to their portfolios without an overall strategy in mind, said Vincent Catalano, author of Sectors & Styles.

"My sense is that many individuals invest in ETFs . . . to make a bet in gold, health care or technology. They don't build well-diversified portfolios using ETFs," Mr. Catalano said.

"ETF investing, the way I recommend it, it's not fun, it's not sexy," he said.

Mr. Catalano recommends buying ETFs that correspond to 10 major U.S. market sectors, which in turn mirror the economy. Proportion your money to each sector by market weight. For sectors you dislike, buy less, and for those you are keen on, buy more.

Rather than picking stocks that may or may not participate in a sector's boom, Mr. Catalano says ETFs will offer exposure without requiring a great deal of money or risk. "The worst thing is to lose money. The second-worst thing is to be right but have the wrong horse. With ETFs, now you're safer and you stand a chance of making money."

One reason ETFs are popular is misleading statistics that show index funds generally outperform actively managed equity funds, said David O'Leary, a Toronto-based manager of fund analysis at research firm Morningstar Inc. It's true that some funds labelled "actively managed" underperform the indexes they follow; many of these hover close to the index and do not take big bets on particular stocks, he said.

Over time, their returns will be eroded by fees that are higher than those for ETFs.

So why label funds "actively managed" if they really aren't? Fund companies can command higher fees for them, Mr. O'Leary noted. "When you're investing the index and charging 2.5-per-cent MER, it's a recipe for disaster," he said. "A lot of them are not making big enough bets to make returns after you factor in the MER."

A savvy investor should do some digging and find out which equity funds are truly actively managed; they stand a better chance of beating ETFs, he said.

Mr. O'Leary suggests comparing an actively managed fund's sector weights with the index sector weights. If they're similar, also compare stock weightings to see whether the fund is taking bigger bets. Those that do will have better odds of outperforming ETFs that follow the same index, he said.

Theresa Ebden is an associate producer for Report on Business Television.