Montage of Russian rouble against US dollar
What happens to an ETF when the underlying securities it is supposed to track are not trading? © Kacper Pempel/Reuters

Exchange traded funds are meant to simplify investing. These baskets of securities trade on stock markets like a single equity. They have allowed investors to participate in previously inaccessible parts of the market cheaply.

But what happens to an ETF when the underlying securities it is supposed to track are not trading? The crisis in Russia is putting the ETF structure and its promise of “hyper liquidity” to the test.

The Russian stock market is closed and that has body slammed some specialist ETFs. Direxion will liquidate and close its leveraged Russia ETF, Direxion Daily Russia Bull 2X Shares, on March 11. Other fund managers have stopped taking new cash. BlackRock, VanEck and Invesco have all temporarily suspended primary trading, or creation of new shares, of one or more of their Russia ETFs.

The sheer volatility seen in Russian assets has had strange side effects. VanEck’s Russia ETF (RSX) is down 65 per cent over the past month to $8.26 a share, but is trading at a substantial premium to its net asset value of $2.98. BlackRock’s iShares MSCI Russia ETF (ERUS) closed on Tuesday at $12 against a NAV value of $5.11.

Critics say the mismatch between ETF shares and underlying prices shows traders responsible for keeping the two in balance are struggling. Others argue that the premium is a sign the structure is working. No one really knows what underlying securities are worth because trading is frozen. Opportunists may be buying in at a valuation they hope is artificially low.

Trading volumes lends credence to this thesis. Dealings in ERUS on Tuesday were nearly four times the 30-day average. RSX recorded twice its 30-day average trading volume.

ETFs have been put to the test before. The Egyptian stock market closed for a month in 2011 and the Greek bourse shut for a while in 2015. The ETFs continued to trade.

The difference this time is the sheer scale of Russia’s economic isolation. The problem for US traders is that sanctions may prohibit them from dealing in Russian shares once the Russian market reopens. The chances of balancing ETF shares with underlying assets would then be nil.

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