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.
In portfolios in which effective diversification is the goal, it makes more sense to focus on commodity currencies and certain emerging market currencies. That would include Australia and Canada. Australia managed to avoid a recession during the downturn, and the decline in Canada has been much less severe than in the U.S. While neither destination is riskless, they are on firmer economic footing as demand for commodities from China appears to be on the rise again. That puts upward pressure on prices, so, even though Australia exports more to China than Canada does, both can benefit. In the same vein, the WisdomTree Dreyfus Brazilian Real Fund ( BZF) has benefited from this effect and will continue to do so for as long as this run in commodities lasts. Some may also think of the WisdomTree Dreyfus New Zealand Dollar Fund ( BNZ) in this context, but that may not pan out as hoped for. New Zealand has several things going for it, like its trade with China and what appear to be relatively early signs of recovery from the global recession, but the country is more of an agricultural- and dairy-based economy, as opposed to various types of ores or energy products that can be mined or drilled. That makes the kiwi, as its currency is known, unique. In addition, New Zealand Prime Minister John Key has called for a correction down in the kiwi dollar after such a big run-up. A case can be made for owning the WisdomTree Dreyfus Emerging Currency Fund ( CEW), which provides exposure to the Israeli shekel, Chilean peso, Turkish new lira and the Chinese yuan, among others. WisdomTree also has a yuan fund. The idea here is that these markets are unambiguously ascending, and, even if the ride is bumpy, the cliche about the ride up being much easier than trying to hold on to the top spot, which is where the greenback is, rings true.
There needs to be a bit of context to currency-investment idea. The rally in equities that has been under way since March has been fueled, in part, by a 15% decline in the U.S. dollar index. That same index rallied 22% during the second half of last year as stocks were imploding and rallied again during the first quarter of this year as stocks dropped again. Loading up on foreign currencies after a big drop in the dollar could be the epitome of buying high, but slowly wading in with an eye to the long term could serve as effective diversification. Even if you're in the dollar-going-to-zero camp, it's crucial to realize that it wouldn't ever be a straight line, and, when the dollar does rally, counter-trend or otherwise, currency ETFs will go down meaningfully.