Questions have been raised about ETFs even prior to such headlines. European regulators have been concerned about the extent to which investors understand the risks inherent to trading ETFs. And in the US, the Securities and Exchange Commission and the Commodities and Futures Trading Commission have been examining the role of ETFs in the “Flash Crash” of 2010.

But these questions are largely arising because ETFs are relatively new instruments, so both investors and regulators are still learning about how ETFs are constructed and utilized.

In contrast to traditional mutual funds which trade securities as investors purchase and redeem shares of a fund, ETF sponsors trade the basket of stocks underlying these securities infrequently. That’s because ETF sponsors only trade with what are known as authorized participants (AP). APs tend to be large investment banks like Goldman Sachs.

These institutions are responsible for obtaining the underlying stocks needed to create shares of an ETF. They buy shares of stock on either the open market or one of the secondary markets shared among institutions, such as “dark pools,” or use shares from their existing inventory. They then present those underlying stocks to an ETF sponsor, which constructs the ETF and offers the AP shares of the ETF in exchange for procuring the underlying stocks. The AP then either retains the ETFs as a holding or makes a market for them. The process works in reverse when APs redeem ETF shares.

This process provides the necessary liquidity to prevent ETFs from trading at significant discounts or premiums to their net asset value, addressing a serious shortcoming that has plagued similar instruments, such as closed-end funds (CEFs).

It also means ETFs can’t be culpable for the growing market volatility over the past few years. A simple look at volume charts illustrates why this isn’t the case. In the US, ETFs which track the S&P 500 currently hold more than $100 billion in assets and have an average daily trading volume of around 400 million shares. As a result, you might expect to see much heavier trading in shares of companies like General Electric (NYSE: GE), Exxon Mobil (NYSE: XOM) and Pfizer (NYSE: PFE) because they comprise some of the heaviest weightings in the S&P 500. Thus far, however, there have been no apparent spikes in trading volumes for these stocks that are directly correlated to their use in ETFs. As such, US regulators’ concerns about ETFs have largely abated.

The real issue is how bad actors have used ETFs; something that can’t be blamed on the ETF structure itself. When an insider illegally trades individual shares of a company’s stock, there is no outcry demanding that trading in equities be banned. Instead, reasonable people understand that there will always be someone hoping to illegally profit at another party’s expense.

Lately, European regulators have been concerned about synthetic ETFs, which don’t yet exist in their purest form in the US due to regulatory restrictions. Synthetic ETFs use derivatives to mimic the behavior of an index. While exchange-traded notes have attributes that may make them appear similar to synthetic ETFs, they’re ultimately rather different and account for only a tiny fraction of exchange-traded product assets.

We maintain a healthy skepticism toward products which employ futures and derivatives to build their market exposures. There are only a few such products that we endorse, so we are largely sympathetic to the concerns of European regulators in this instance.

Although it’s tempting to blame ETFs for these problems because they are still a relatively new asset class, investors should expect the traditional asset classes, such as stocks, bonds and mutual funds, to continue to experience similar depredations. There are always going to be market actors seeking to press every advantage through both radical and illegal methods, regardless of whether they use stocks, bonds, mutual funds or ETFs to achieve their end. That’s a problem with which securities regulators will always have to contend, but that doesn’t mean investors should abandon ETFs or any other security that helps them achieve their investment goals.

What’s New

State Street rolled out three new subsector ETFs last week: SPDR S&P Aerospace & Defense ETF (NYSE: XAR), SPDR S&P Health Care Services ETF (NYSE: XHS) and SPDR S&P Software & Services ETF (NYSE: XSW).

All three ETFs use modified equal-weight indexes, which means they’ll include exposure to stocks spanning the full range of market capitalizations. Each ETF charges a relatively cheap 0.35 percent expense ratio.

Portfolio Roundup

Our Model Portfolio declined 1.8 percent last week, beating the 2.7 percent loss posted by the S&P 500. It did underperform the MSCI EAFE index, however, which gained 2.2 percent.

Energy was the major drag on our performance last week with Market Vectors Coal (NYSE: KOL) and iShares Dow Jones US Oil Equipment Index (NYSE: IEX) both declining by around 7.5 percent. While there were no specific news items affecting either of these ETFs, the continuing worries over the European sovereign-debt crisis and the possibility of a slowdown in the Chinese economy has left many speculating that energy demand could fall in the wake of another global recession.

Those are legitimate concerns given the current state of the global economy, but our outlook remains unchanged. We’re still expecting growth to remain slow and uneven as consumers continue to deleverage and governments debate how to address their unsustainable debt burdens. Until there is greater progress toward resolving these problems, GDP growth will likely remain sluggish.

Nevertheless, we still expect European leaders to reach a constructive solution to their sovereign-debt crisis. Although the situation there raises some troubling existential questions for the Europeans, it isn’t in any nation’s interest for the grand experiment of the European Union to fail given the dire trade and balance sheet ramifications. While that doesn’t preclude the Europeans from allowing a nation such as Greece to default, authorities understand that they need to have a well-conceived plan in place for preventing the freezing of credit markets. There’s no reason this can’t be an orderly process as long as European leaders can agree upon a course of action.

In the case of China, slower growth should be expected after its turbocharged growth over the past decade. No economy can sustain that pace of economic growth forever.

Even so, Chinese monetary and fiscal authorities remain more concerned about inflation rather than slowing growth. Given such fears, Chinese authorities have been increasing interest rates and tightening their money supply in order to cool their overheated equity and real estate markets. Should their growth slow to dangerous levels, Chinese authorities should still have the monetary tools available to provide the necessary easing.

We’re closely monitoring the situation in the global markets, but we still don’t see the need to make any drastic portfolio adjustments for now.

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