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Many market pundits recommend Emerging Market stocks without understanding the impacts of local currency volatility in a portfolio's performance. As an example, let's take a quick look at what happened with the Brazilian Real and Bovespa in the last three months.

Looking at the chart below, Bovespa (BVSP, in blue) reflects the market in local currency, the Brazilian Real (BRL). If an international investor looks at that index alone, it seems like the recent, double-digit BRL devaluation has never occurred. Hence, a better representation of the currency devaluation effects on a portfolio is by taking two funds, priced in US dollar, and that correlate highly with Brazilian stocks: EWZ (a Brazil ETF, in red) and MCLTX (a LatAm fund, in green). Observe how they compare with BVSP for the last three months.

(Click chart to expand)

The BRL devaluation trend started sometime in September, when European woes worsened. Observe how the green and red lines (dollar-based funds) decoupled negatively from the blue line (Bovespa, in Real). This effect can be observed more clearly in November, when the Real devalued the most.

Here are a couple of ways for an investor to hedge his portfolio against this currency volatility when investing in the EWZ or another dollar-denominated Brazilian (or LatAm) fund:

  • do it through options, like buying EWZ puts when the markets are "calmer" (so option "premiums" are less expensive);
  • or by "shorting" the Brazilian Real as you are "long" a Brazilian fund (or stock)

Either way, these issues must be taken into account when playing any emerging market stock.

Source: Effects Of A Currency Devaluation On Brazilian Stocks And ADRs