ETFs MAY BE THE investment vehicle du jour, but should you buy into one for your golden years?

ETFs, or exchange-traded funds, are hybrid investments that track indexes, commodities and baskets of assets like index funds, but trade like stocks. They are growing rapidly: As of April, there were 888 ETFs in the U.S., with $829.5 billion invested in them. That s up from 742 ETFs a year earlier, with $530.8 billion in investment assets, according to financial services firm State Street.

As ETFs catch on with the investment community, a handful of company-sponsored 401(k) plans are beginning to offer them as an option in saving for retirement. One advantage is that they are getting cheaper, at least for now. Vanguard announced last week that it would allow its brokerage clients to buy and sell the fund company s entire line up of 46 low-cost ETFs commission-free. Fidelity and Charles Schwab (SCHW) announced similar moves earlier this year. (For more on Vanguard s ETF announcement, watch our interview

Of course, that doesn t mean you should jump into an ETF. For one thing, ETFs that follow a particular index may contain tracking error -- that is, they may not always provide the same returns as the index they track, says Philip Spoljarick, an accredited wealth management advisor at Charles Schwab in Southfield, Mich. We want, as an investor in ETFs, the return to be close to the return that the index would have generated. Tracking error can be caused by a variety of factors including a fund s investment strategy. For instance, some funds use a so-called replication strategy -- that is, managers will buy the same stocks at the same weights as the underlying index. While fees may be higher with this strategy, tracking error tends to be minimal. Other funds attempt to optimize their investment structure. For instance, managers may only purchase a subset of the index's stocks hoping to provide similar performance to the full portfolio, at a lower cost to trade.

Newer ETFs, or those that have low trading volumes, can contain greater tracking error simply because they may track newer or lesser-known benchmarks that are harder to replicate, says Spoljarick. To protect against this, he looks for equities-tracking ETFs that have a minimum three-month average daily trading volume of one million and fixed-income ETFs that average 500,000. He also prefers ETFs with a minimum of $20 million in assets.

In addition, ETFs aren t free. Even if a company drops the transactions costs, which typically range between $12 and $45, ETFs still have embedded expense ratios to keep an eye on, say advisors.

Here are some questions to consider before turning to an ETF to build your nest egg:

Is it a cheap way to track the market?

Conventional wisdom holds that investors should have exposure to the broader markets. Many mutual funds have long served this function, but ETFs may be able to do it cheaper. One reason: One reason: Because ETFs can passively track an index such as the S&P 500 or the Dow Jones Industrial Average, they tend to have low annual operating expenses -- generally running 0.08% to 0.20%. While actively-managed or specialty ETFs can be pricier, ETFs overall don t charge a sales load -- that is, a fee levied on the purchase or sale of shares.

Mutual funds, on the other hand, can cost upwards of 2% of assets and potentially offer higher returns. Take the Fairholme fund (FAIRX), which is managed by Bruce Berkowitz, recently named Domestic Stock Fund Manager of the Decade by Morningstar. The Fairholme fund earned a 13.2% 10-year annualized return, beating the S&P 500 index by 14 percentage points over that same period. Berkowitz s fee may be 100 basis points, but investors are paying 10 times more for his expertise than they would if they just tracked the returns of a major index, says Joe Gordon, managing partner at wealth advisory firm Gordon Asset Management in Durham, N.C.

Does it limit the single-stock risk?

Unlike mutual funds, where investors might only have an idea about the top 10 holdings, ETF investors typically know exactly what they re buying, says Spoljarick. You can see on a day-to-day basis, in most instances, what that ETF owns, he says. With that information, investors can avoid buying too many shares of the same stock otherwise known as portfolio overlap, Spoljarick says. They could have gotten stuck with mutual funds that all own AIG, or worse, Lehman Brothers.

Does it give you exposure to an asset class you couldn t get otherwise?

ETFs can help investors get into an asset class that may be too expensive on its own. Say, for example, you want to invest in gold, but don t want the hassle of buying actual bullion. Purchasing a gold ETF, where gold is the only commodity being traded, may offer a compromise. Likewise, ETFs can help investors boost their exposure to non-core and core asset classes such as U.S. large cap, U.S. small cap, and international stocks, which may be hard to get with active managers, says Gordon. Sometimes active management isn t a better deal when you look at some asset classes, says Gordon.

Can it help you hedge?

ETFs, like other investments, can offer hedging opportunities. If an investor is concerned that inflation might bubble up in the future, he could buy an ETF that purchases Treasury Inflation-Protected Securities, or TIPS, such as iShares Barclays TIPS Bond Fund. We look at ETFs as a means of filling holes that you have with active managers and gaining exposure to certain asset classes, inexpensively, says Gordon. Another way to hedge would be through an inverse ETF such as the ProShares Short Dow 30 ETF, which inversely tracks the Dow.

But keep in mind that investments like inverse ETFs are volatile and are typically bought in high volume by sophisticated investors like hedge funds, says Spoljarick. These types of investments are not [always] appropriate for average retirees, he says.

Is the potential for high returns worth the risk?

Leveraged ETFs enable investors to double or triple the performance of various indexes or sectors -- up or down. Essentially, being able to triple the S&P s performance or shorting the Dow s offers investors another investment hedge, says Joe Black, a wealth advisor at FSG Wealth Management in Stone Mountain, Ga. It allows an individual to make a sophisticated market play without understanding options or derivatives, he says.

Note, however, that leveraged ETFs, like inverse ETFs, carry significant downsides and aren t ideal for lay investors, says Spoljarick. After all, when you have ETFs that return three times the average performance of an underlying investment, who s to say that investment won t tank and leave you footing three times the bill?