Investors in Russian ETFs have suffered for a long time.

In more than 5 years, the **Market Vectors Russia ETF** (RSX) has barely moved. However, is this ETF severely undervalued? Let's look at some of the core financial measures, as reported by Yahoo.

P/E TTM: 6

Yield: 2.1

NAV: 34.01

Price: 28.74

5-year Alpha: 3.26

5-year Beta: 1.54

So, what does the above tell us? I think in a nutshell it tells us that this ETF is significantly undervalued. Here are five reasons:

Trading at 15% discount to NAV

Over 5-years 3.26% risk-adjusted excess return to market

While volatile, risk is moderate

Price to Earnings is super low

There is a moderate yield to boot

There was an earlier article on 3 Reasons To Consider Russia which highlighted several other reasons why Russia may be the place to invest in 2013. In addition to the cheap valuation as mentioned above, it also mentions that Russia has surprising profitability. I quote:

While there are some very legitimate reasons that Russian equities should be this cheap, profitability is not one of them. Companies on the MICEX exchange, have a return-on-equity (ROE) of over 18%. This is in line with both Russia's long-term average as well as the average for other emerging markets. In fact, when you compare valuations with market profitability, Russia appears to be one of the more under-valued markets globally.

So, there seems to be a strong reason to go long the RSX ETF, or another popular alternative, the **SPDR S&P Russia ETF** (RBL). Let's look at some of the core financial measures, as reported by Yahoo.

P/E TTM: 5

Yield: 1.75

NAV: 31.35

Price: 28.14

It is clear from the above that the investment case for RBL is just as strong as that of RSX. But can investors do even better? I believe by buying puts on the **Direxion Daily Russia Bear 3x Shares ETF** (RUSS), which aims to return 3 times the negative return on the RSX, investors can double their return in 6 months.

The core case is simple. If RSX does well, RUSS should do very, very poorly, as it replicates three times the performance of RSX, but in the negative direction. However, since RSX is quite volatile (beta of 1.54) this leads to further erosion in the price of the 3x leveraged ETF.

This is a common feature for leveraged ETFs where the underlying is very volatile. I had earlier written an article named An Almost Risk-Free Way For Annual Return Of 50%+ to exploit this phenomenon. The strategy used there was to short both 3x leveraged bull and bear ETFs, and gain over time from the volatility loss. However, as several readers pointed out, while over a year this strategy yields a lot of return, there is considerable volatility in-year, and hence downside risk.

Since the strategy is to short, the downside risk is really infinite. I therefore decided to simulate the same strategy with put options, instead of shorting, thus limiting the downside.

First, let's examine why leveraged, inverse ETFs erode over time from volatility. This is especially true when the underlying has very little drift, and lots of volatility. Let's imagine an underlying that has 0 drift (i.e., the average daily return is 0%). This underlying goes up 10% one day, 10% down the next, and repeats this for 20 days. The volatility is 10%, but the average daily return is 0%.

After 20 days of this up and down journey, the underlying will be at $90.4. A 3x leveraged ETF on it, bull or bear, however, will at $38.9. So, even though the underlying has dropped less than 10%, the 3x leveraged bullish ETF has dropped more than 60%. It is even worse for the leveraged bearish ETF, which should have been up, but instead is down 60%+ as well. The below graph shows how the three will behave.

So, it seems that when the underlying has very little drift but lots of volatility, the leveraged 3x bear ETF on it will do really, really poorly. I set out to examine that for RUSS. This is how this ETF has done since inception.

As expected, the ETF has done very poorly. While the underlying is down 18%, the 3x leveraged inverse ETF is down 54% instead of being up. It may be rather tempting to short RUSS right away, however, as mentioned before, shorting is rather risky, so I decided to use puts instead.

The June expiration 15 strike puts on RUSS are trading at $1.90/2.90 (bid/ask). So what is the expected profit of buying these puts? A Monte Carlo simulation is handy.

Trials = 5000

Put = rep(-2.9, Trials)

RUSS = rep(16.66, Trials)

for (i in 1:Trials){

for (j in 1:120){

RUSS[i] = RUSS[i] *(1+rnorm(1,mean=-0.001,sd=.101))

}

Put[i] = Put[i] + max(0, 15 - RUSS[i])

}

MPut = mean(Put)

SPut = sd(Put)/sqrt(Trials)

Essentially, what this does is take the daily average return and volatility for the RSX ETF, multiplies it by -3, and arrives at the daily average expected return (-0.1%) and volatility (10.1%) for the RUSS ETF. Then it generates 5000 sets of 120 daily returns that match this average return and volatility pattern, and estimates for each of the 5000 sets what the end price would be for the RUSS ETF, starting from the current price of $16.66. For each of the end prices, it checks to see what will be the value of the put.

After initial investment of $2.9 to buy the put, the ending value of this trade have a average of $3.39, and a standard deviation of $0.07. Hence, the 95% confidence intervals are $3.25 to $3.53, or a return of 112-122%. Downside is protected, and the returns are slightly better than outright shorting of RUSS.

So, there you have it - more than double your money in 6 months. Of course, you are risking 100% downside as well, as the put may expire worthless. But the simulation shows that the odds of that are miniscule. If in the meantime there is a rally in the Russian market, the returns will be even better, as there will be positive drift on the RSX and even more negative drift on the RUSS.

Just to illustrate this point, if the negative drift of RUSS goes from -0.1% to -0.2%, then the potential returns are up to 150% in 6 months. Looking at the chart above, there seems to be positive drift every year in the first few months of the year on the RSX, so I think it is not unreasonable to expect a doubling of the money in 6 months by getting a put with 15 strike and June expiration on the RUSS ETF.

To that, I can only say, Yippee Ki-Yay, Mother Russia!

**Disclaimer:** This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice. I am merely stating what I personally plan to do for my own portfolio.

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