Protect Your Portfolio Against Currency Fluctuation

The U.S. dollar looks hearty against most of the world’s major currencies, but it likely won’t stay strong forever. Measured by its real effective exchange rate, the dollar continues to trade above its 10-year average, and many analysts have been calling for a dollar correction.

When the dollar loses its might, as many strategists think it could, its impact won’t just be on foreign travel or imported goods: It could hit closer to home—your investment portfolio.

So what can investors do to dampen the impact of a falling dollar dragging down their portfolio? One knee-jerk reaction of investors is to consider buying other currencies through a currency trader to offset the falling dollar. But that strategy can be rife with high costs and can also be tricky; it requires an understanding of the complex economic and financial factors tied to the target currency.

The currency impact on portfolios could be enough to consider strategic moves to soften the blow. Here are some strategies to make a falling dollar work in your favor.

Stock Up on TIPS

US Treasuries have always acted as a safe harbor when clouds form on the horizon. TIPS, or Treasury Inflation-Protected Securities, are government bonds indexed for inflation. These are designed to be a domestic inflation hedge—but are also a hedge against a weakening dollar because their prices hold steady when Treasury prices decline. TIPS can be bought in $100 increments through a bank, a broker or directly from the US Treasury. Bonus: Unlike foreign equities or foreign currency funds, TIPS are backed by the full faith and credit of the federal government.

Diversify with EM Debt

When the dollar loses value, it favors foreign countries holding lots of dollar-denominated debt. A weaker dollar makes it marginally easier for those countries to service their debt. Emerging market bonds—and in the mutual funds that own them—tend to perform better in this environment and can be a good way to reduce the impact of the weakening dollar. This strategy may not turn a losing hand to a winning hand but could help reduce losses.

Consider Commodities

When the dollar weakens, the price of raw materials decreases and the demand for commodities often increases. Big commodities—metals, energy, livestock, agriculture products—have been a staple of inflation hedges and diversified portfolios for decades. Investors can look to a more direct and more volatile approach by investing directly in single commodities such as oil or copper. A better option for many is to invest in a diversified basket of commodities such as via a mutual fund or exchange-traded fund (ETF).

Up Exposure to Foreign Equities

A weakening dollar also provides the opportunity to look to foreign equities through ETFs. As the dollar falls against other currencies, the greater the value of the foreign shares in the home country currency. When the share value is converted to dollars, the foreign currency can buy more dollars than previously, and the shares are in turn worth more in dollar terms. Note that foreign equity ETFs that hedge their positions negate the benefit of a weak-dollar hedge.

Own a Basket of Currencies

Another good dollar hedge is to invest in a broad-based currency ETF. These ETFs hold foreign currencies in interest-bearing overseas accounts. The use of foreign currency ETFs hit their stride during the recession around 2008, as the dollar hit bottom against the Euro. Their value is calculated vis-à-vis the dollar. You can choose from a wide range of options, including single-currency ETFs and multi-currency ETFs, as well as ETFs that bet against currencies by taking short positions. These ETFs carry management fees as well as brokerage fees since they are traded like stocks, but for most investors it's still a better option than trading directly in currencies.

Whether the dollar strengthens further or falls, investors should understand the effect it and other currencies have on their portfolios. Luckily there are many strategies to offset such swings—or profit from them.