As banks back away from exchange-traded notes, investors are left vulnerable

Exchange-traded notes, or ETNs, once popular among banks and traders, is falling out of favor, leaving investors and their $4 billion plus holdings vulnerable to abnormal price swings.

Some 61 ETNs, about 33% of the U.S. ETN market, continue to trade despite obstacles to the creation of new shares, a crucial mechanism that keeps the notes’ price in line with the assets they’re meant to track. Others have been delisted from major stock exchanges, trading only in gray markets where there is little price transparency. Unsuspecting investors may find themselves stranded in an orphaned product, or they may overpay for a crippled ETN, not realizing that the price has veered away from its real value.

“There are these zombie ETNs” that may trade normally at first but then become more volatile with time, said Dave Nadig, CEO of ETF.com.

ETNs are similar to their better-known cousins, ETFs, with one big difference.

• ETFs own the underlying assets that they track, like Japanese equities or oil futures. If the ETF issuer goes bankrupt, the fund’s assets aren’t affected.
• ETNs, on the other hand, are debt issued by a bank, similar to a corporate bond. If the issuing bank goes broke, investors can be left with pennies on the dollar, as ETN investors learned when Lehman Brothers Holdings Inc. collapsed in 2008.

Banks are backing away from the ETN business. Regulatory pressure has forced banks to set aside more capital to cover potential losses, and ETNs may not be the most profitable use of their shrinking balance sheets. But some ETNs can be hard to kill. Like corporate bonds, some ETNs can’t be closed by the bank until they mature, often 20 to 30 years after they were issued. Banks can’t force investors to liquidate, and some notes can languish in the market for years.

Zombie ETNs create additional risks for investors. In January, the iPath S&P GSCI Crude Oil Total Return Index ETN, whose ticker symbol is OIL, was temporarily closed to new issuance. The price jumped to a 48% premium over the value of oil futures. Then Barclays, the ETN’s issuer, put out an alert about the premium, and the price collapsed. The ETN suffered a 17% decline - its biggest one-day drop ever - on a day when oil prices rose.