The Ups and Downs of Currency Funds

NEW YORK (TheStreet) -- Currency exchange traded funds swelled by $548 million in net new money last month, bringing total inflows to $1.2 billion this year. The barrage of headlines about the weak dollar created enormous demand. That brings up the question of what, if any, role should currency funds play in a diversified investment portfolio.

The myriad of strategies, investment goals and funds makes answering the question a multi-faceted endeavor. The starting point is that cash is an asset class. In allocating to stocks, bonds and cash, it makes sense to consider foreign exposure for all three. For diversification, U.S.-based investors should seek out currencies that are least like the dollar. Note that this strategy contrasts with what might be the best currency funds for short-term trading.

Some ETFs track individual currencies, others follow baskets of currencies in which members have fundamental characteristics in common, and a couple are designed to deliver a specific effect without necessarily tracking a specific currency.

For short-term trading, the Rydex CurrencyShares Japanese Yen Trust(FXY), Rydex CurrencyShares Euro Trust(FXE), Rydex CurrencyShares Australian Dollar Trust(FXA) and Rydex CurrencyShares Canadian Dollar Trust(FXC) are the largest and most liquid.

The PowerShares DB US Dollar Index Bullish Fund(UUP) and the PowerShares US Dollar Index Bearish Fund(UDN) are also liquid trading vehicles that enable directional trades on the U.S. dollar. They track the U.S. Dollar Index, a basket of currencies comprising 58% euros, 14% yen, 12% pound sterling and others.

The United States is a service-based economy with a decent-sized manufacturing base, similar to Western Europe and Japan. All three face enormous deficits and demographic problems that reduce the chance that the euro and yen can be the most efficient currencies for diversification.