Find out what happens to a stock portfolio when you add dollars – 10/05/2023 – From Grain to Grain

Most investors confuse how to use foreign exchange as a portfolio hedge. About two weeks ago I wrote an article explaining what happens to a fixed income portfolio when we add dollars. At that moment, I showed how wrong the view is that adding dollars protects a fixed income portfolio. In that case, I showed that the portfolio loses return and its risk increases. Precisely an effect contrary to what was desired. I now explain the consequence of adding the dollar variable to a stock portfolio.

To illustrate the effect of exchange rates on the portfolio, I simulated the return in two situations over the last two decades. The addition of dollars to a portfolio of Brazilian stocks and to a portfolio of American stocks.

To do this, I used the monthly returns of Ibovespa as the Brazilian stock portfolio and the S&P500 as the American stock portfolio.

	Average annual return	Risk	Return/risk
Dollar	2.87%	15.7%	0.18
Ibovespa	10.29%	22.8%	0.45
S&P500	7.54%	14.8%	0.51

In the last two decades, the average return per year, the risk measured by volatility and the return-to-risk ratio for the three variables (Real/dollar exchange rate, Ibovespa and S&P500) are presented in the table above.

Understand how the dollar is a risky instrument. Its risk is greater than that of American stocks. However, its average annual return over the last 20 years has been just 2.87% per year.

Unlike the fixed income portfolio, adding FX to the two equity portfolios has a benefit. In addition to the resulting return being greater in both, the risk of the aggregate portfolio was lower in the case of investing in Brazilian shares. In both stock portfolios, the return-to-risk ratio improves with the addition of exchange rates.

When there is risk, there is a benefit in adding uncorrelated assets, as is the case with shares and foreign exchange. Often, when one’s feedback is positive, the other’s is negative. Thus, the fluctuation in returns is reduced and the return-to-risk ratio is improved.

The table below presents the average annual return, risk and return-to-risk ratio in the case of the aggregate portfolio Ibovespa with dollars and S&P500 with dollars.

	Average annual return	Risk	Return/risk
Ibovespa w/ Dollar	13.46%	17.9%	0.75
S&P500 w/ Dollar	10.63%	16.3%	0.65

In the graph above, I show the evolution of an investment of R$10,000 in September 2003 in Ibovespa (red line) and in an aggregate Ibovespa portfolio with dollars (blue line).

Therefore, the dollar serves as protection if you have a portfolio of risky assets like stocks. But, it can have an unfavorable effect if you are a conservative investor and have a fixed income portfolio only.

Michael Viriato is an investment advisor and founding partner of Investor’s House.

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