Is This the Answer to the Dollar's Demise?

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The dollar's recent weakness has some investors at the brink of panic. Increasingly, investors are looking for ways to protect themselves against further declines in the dollar, and interest in investments designed to provide that protection has risen dramatically. But which investments do that job the best?

Crisis of confidence
The extraordinary events that the U.S. has faced since the financial crisis began last year have thrown the investing world into disarray. After rising strongly from record-low levels against the euro last summer, as investors sought the dollar's safe-haven status during the worst of the market meltdown, the dollar has given up nearly all of those gains.

The dollar's steep losses have investors fearing the worst. In light of huge budget deficits, there is speculation that China and other foreign investors will stop buying Treasuries, forcing rates to skyrocket and pushing the government toward a possible insolvency. Oil prices have more than doubled from the year's lows, as investors seek hard assets and commodities to hedge inflation risk. Gold has sustained its rise through the $1,000-per-ounce level, and bullish investors see the potential for gold prices to double or more in the coming years.

Investors have also piled into stocks that are poised to benefit from those trends. Just take a look at the performance of some energy- and gold-sensitive stocks in the past year:

Stock	1-Year Return
Freeport-McMoRan Copper & Gold (NYSE: FCX)	196.1%
Barrick Gold (NYSE: ABX)	91.3%
Goldcorp (NYSE: GG)	148.5%
National Oilwell Varco (NYSE: NOV)	96.9%
Anadarko Petroleum (NYSE: APC)	127.4%
Occidental Petroleum (NYSE: OXY)	85.8%

Source: Yahoo Finance, Oct. 21.

These commodity-related plays have effectively hedged against the dollar's drop. But there's no guarantee that they'll stay linked in the future. If you want direct protection against a falling dollar, then you'll want to take a look at currency ETFs.

Dabbling in the currency market
Foreign exchange markets are huge, with an estimated $3.2 trillion changing hands daily, according to the latest 2007 triennial survey of the Bank for International Settlements. Until recently, they were somewhat difficult for small investors to use, with special forex or futures accounts necessary to trade.

Currency ETFs have made forex trading a lot easier for average investors. In essence, you can now buy shares that track the performance of one or more foreign currencies relative to the U.S. dollar. If interest rates in that particular country are high enough, then you can even earn income on your investment, just as you do in your dollar-denominated money market funds.

For instance, Rydex's CurrencyShares ETFs sell shares equal to 100 euros, Canadian dollars, British pounds, or Swiss francs. You can also get shares that are worth roughly 10,000 yen, or 1,000 Russian rubles, Swedish krona, or Mexican pesos. Rival WisdomTree also offers ETFs, although their share prices don't match up with round amounts of foreign currency.

The value of cash
Although currency ETFs haven't been around for long, they've done a good job so far of tracking movements in the dollar's value. But that doesn't mean they're a perfect investment.

For one thing, currency markets can be volatile -- in both directions -- and these ETFs reflect that. Between July 2008 and February 2009, for instance, the CurrencyShares Euro Trust (NYSE: FXE) lost 18% of its value. The ETF tied to the British pound lost even more ground, falling 27%.

In addition, even though these ETFs sometimes generate income, they track short-term rates. Right now, rates in many countries are so low that the related currency ETFs pay no yield at all -- and over time, ETFs may even lose value if their expenses exceed the income their investments generate.

Finding the right mix
Just as having all your U.S. investments in cash doesn't make sense, it's smart to have a variety of foreign-denominated assets to protect yourself from your exposure to the dollar. Foreign stocks provide a good counterbalance to domestic stocks. International bonds let you both earn significant income and benefit from favorable currency moves. Yet as a portion of the assets you keep completely liquid within your portfolio, currency ETFs can give you the diversification you want.