How to Fall Nearly 80% and Still Be Overvalued

If you weren’t already familiar with the VanEck Russia ETF (RSX) before this month, you’ve likely heard of it now.  It had been the preferred way for many individual investors to gain exposure to Russian shares long before the recent Ukraine invasion put the region on everyone’s radar, and sported a market capitalization of over $2 billion.  Like many other assets of its type, we have since seen its value implode.

RSX closed at $25.50 on February 16^th.  Yesterday it closed at $5.79.  That is a drop of over 75% in just over two weeks.  (It is trading even lower as I type this).  Despite that stunning plunge, RSX appears wildly overvalued!  It has a Net Asset Value (NAV) of $0.89.  Yes, that implies that RSX is trading over 5X its NAV. 

Here is a quick reminder about the relevance of NAV to the pricing of an Exchange Traded Fund (ETF).  The NAV tells us what the holdings of an ETF are worth on a per share basis.  Highly liquid ETFs, like SPY and QQQ, rarely deviate from their NAVs in a meaningful way.  If the ETF trades below its NAV, arbitrageurs would buy the ETF, simultaneously sell its holdings in the proper ratio, then submit a request with the sponsor to redeem the ETF.  If the ETF trades above its NAV, the arbitrageur would sell the ETF short, buy the holdings, and submit a creation request.  Request are fulfilled at the end of the day at the closing NAV, but that is irrelevant if the trader has already locked in a spread on their arbitrage activity.

Large trading firms set up accounts with ETF sponsors that enable them to create and redeem shares of the ETF for a relatively modest fee.  The creation units tend to be quite large, making this activity out of reach for small investors, but because so many firms are active in this role (it was something I engaged in routinely when I was a market maker), ETF prices usually hew closely to their NAVs.  When you do see them diverge, it typically reflects some sort of inefficiency in the market.  For example, if the ETF or some of its components are hard to borrow or highly illiquid, it would make creation and redemption more difficult.  It would not be unusual to see the ETF trade in a wider range around its NAV under those circumstances.

As the hostilities began, a friend asked me what I thought might happen to his holdings in RSX and whether it would continue trading.  I thought at the time that the ETF would continue to trade – at lower prices, of course — but become unmoored from its NAV because of the likely impairment in the trading and settlement of the assets held by RSX.  That certainly proved to be the case, as we see from the ETF’s current pricing.  Russian markets remain closed, making a true determination of the fund’s NAV quite difficult, but also forcing VanEck to suspend creation and redemption activity in RSX.  When we unable to either confidently calculate a fund’s NAV nor enable arbitrage activity those who might have more clarity into that value, the ETF can trade with little regard to its perceived fundamentals.

Despite the apparent mispricing, there is no shortage of activity in RSX.  Since the invasion, its average daily volume (ADV) exceeds 35 million shares per day.  That is up about 7X over its prior ADV.  It also means that about 1/3 of its 95 million shares outstanding are turning over each day.  This ETF has crept into the top 25 most active names at our firm and is clearly popular with traders elsewhere.  It has developed a significant following on social media, where a large cadre of YOLO risk-takers see the large drop and heavy short interest as an opportunity to enter a fallen angel at a bargain price.

Even though calculation of the NAV is severely impaired, it is a reasonable estimate from a respected, experience source.  When I saw the ETF trading at over 5X its NAV, I queried my colleagues in stock loan about the borrow rate.  If a stock or ETF is extraordinarily expensive to borrow, it can become difficult if not impossible for short sellers to push the price of an overvalued asset to its fair value.  It is important to remember that short-selling by arbitrageurs add to the market’s efficiency.  As described above, short-selling is often necessary to keep an ETF in-line with its NAV. 

Yet the borrow rate was quoted at about -15% this morning.  While it is expensive to borrow the shares, it is far from prohibitive.  A short seller would need to pay an annualized 15% on the value of any shares he borrowed, which would appear to be a small price to pay if one believes that the fair value of the share is about 80% below the current valuation.  That said, in the current environment this would be speculation, not arbitrage, because of the inability to fairly price the assets or redeem the seemingly overvalued ETF. 

That RSX can stay above $5 is a testament to the power of individual traders mobilized by social media.  We saw it a year ago during the meme stock craze and at various times since then.  This is another.  We will eventually see RSX’s huge valuation differential resolved, but when and how that will occur is an unanswerable question.  In the meantime, plenty of traders are enjoying the action regardless.