Franc Intervention Could Hurt iShares’ Swiss ETF

August 15, 2011

The Swiss franc intervention will hurt ETF investors, but not the ones you think.

Bloomberg reported last week that the Swiss National Bank may temporarily peg the Swiss franc to the euro, in a last-ditch effort to bring the franc’s rally under control. It’s one of the boldest moves a central bank has announced in the past few weeks.

For the Swiss, the move makes sense: The rally in the franc is hurting Swiss exports. The question for U.S. investors, however, is what this means for their investments.

The first ETF to suffer was the Rydex CurrencyShares Swiss Franc Trust (NYSEArca: FXF). After Thursday’s open, FXF traded wildly before finally closing down 4.68 percent. Not a surprise: A peg to the euro ties the fate of the franc to a troubled currency, and suspends much hope of additional upside.

1-Day FXF: Aug. 11, 2011

 

Though FXF investors should be concerned, investors in the iShares MSCI Switzerland Index Fund (NYSEArca: EWL) stand to lose significantly if the franc weakens.

Why? Because investors in EWL are inherently long the franc relative to the U.S. dollar by nature of their exposure to Swiss-listed equities.

For companies doing business in the global market, the axiom on currency has been “the weaker the better.” Weak currencies help firms compete in the global marketplace by lowering the price of their goods abroad. That argument, however, only holds in the long term. In shorter periods, investors actually benefit directly from currency appreciation.

EWL is the poster child for this.

 

EWL: YTD 2011

 

EWL buys securities on the local Swiss market. It makes those investments in dollars, but the securities trade in francs. If the franc appreciates, that translates directly into extra dollars.

Imagine, for instance, that you bought shares of EWL. For the period you held—let’s call it one day—the local stock market didn’t budge. The franc, however, appreciated by 1 percent. If you then sell your position, you have 1 percent more dollars than when you started.

Welcome to the experience EWL investors have had for the past year.

U.S. investors who put their money into EWL have lost only 0.89 percent YTD, while Swiss investors buying the exact same basket of equities in Switzerland are down 16.99 percent. That’s entirely due to the 20 percent-plus rally in the franc over the intervening period.

So while a move to slow down the rally in the franc might help Swiss companies long term, it’s not at all clear it will make up for the losses investors will experience if the Swiss franc depreciates.

Investors in international ETFs should remember that their exposure is not simply a matter of equity performance, but also foreign currency performance relative to the U.S. dollar.

Investors in EWL have some hope. As strong as the Swiss National Bank’s threats may seem, pegging a currency is no simple task. In fact, it’s costly and difficult. Countries that intend to peg their currency have to consistently engage in the global FX markets, often buying up other currencies and selling their own. It could require the Swiss to maintain large foreign currency reserves if they end up being truly aggressive in their efforts to rein in the franc. Just ask the Chinese how much they like being exposed to the dollar for the sake of a cheap renminbi …

For now, all we can do is wait and see what the longer-term implications are. As for the SNB, “Don’t say you will … unless you will.”

 

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