More than 2000 foreign-based companies have their shares currently listed in the US as American Depositary Receipts (ADRs)¹.  The main objective of an ADR listing is to seek access to capital in the United States. However, all foreign companies do not offer ADR programs. Therefore, US investors seeking international diversification using ADRs may be better off investing directly in an equities index or Exchange Traded Funds (ETFs) in the foreign market. This essay compares the merits of investing in an ADR Index of Australian stocks to investing directly in the commonly used benchmark of Morgan Stanley Capital International (MSCI)-Australia Index.

What is an ADR?
A depositary receipt (DR) is a negotiable receipt representing equity in a non-US company. A depositary bank in the US issues ADRs, and each ADR (American Depository Receipt) is backed by a fixed number of underlying shares in the custody of a bank (called the custodian bank) in the foreign market. The depositary bank carries out the responsibilities with respect to the payment of dividends and shareholder voting as stated in the ADR agreement. The objective in creating the ADR is to reproduce the same rights and benefits for the ADR holders as they would obtain by holding the underlying share itself.

ADRs are an easy, convenient way of getting international exposure for a US-based investor without leaving the country. By holding US dollar denominated securities, an investor avoids costs associated with direct foreign investment, such as international settlement, global custody, foreign brokerage, currency conversions and multi-currency accounting. Dividends are also paid out in US dollars.       

According to one of the leading depositary banks, the Bank of New York (BNY), US investors have shown increased interest in ADRs as a means of investing in international shares. For example, the volume of ADR shares traded has grown steadily from 7.3 million in 1994 to 33.1 million in 2003 ².

The BNY began publishing ADR indexes in 1998, which include a composite ADR Index as well as indexes for regions, countries and selected sectors. These indexes provide benchmarks for portfolio managers who invest in DRs.

The ADR Index, denominated in US dollars, is capitalisation-weighted with an adjustment for free-floats that account for trades both in the local market and the ADR market. The Index assumes that dividends are reinvested at the ex-dividend date.

The eligibility criteria used by the BNY for a DR to be included in a corresponding ADR Index are: (i) The ADR must be listed for trading on the New York Stock exchange (NYSE), American Stock Exchange (AMEX), or NASDAQ Stock Market (NASDAQ), (ii) The ADR must be liquid (liquidity rule says an ADR with more than 10-days of no trades in the last quarter is considered illiquid), and (iii) There is no pending liquidation or trade suspensions against the ADR. Generally, the constitution of the index is revised quarterly. According to the BNY, the distinct group of companies included in the index provides the transparency, disclosure and liquidity that U.S. investors desire.

ADRs vs. Direct Investment
Table 2 summarises the average return and risk of the ADR Index compared to both the hedged and unhedged MSCI-Australia Index. The MSCI-Australia Total Return Index is chosen for comparison since this is the most commonly used benchmark by international investors. Dividend reinvestment assumption used in the index calculation is the same for both the ADR and MSCI-Australia Indexes.  The comparison period covers six years from July 1998 to June 2004. The performance of the two indexes is shown in Figure 1 which tracks the value of US$ 1 invested at the beginning of July 1998. 

These results show that the ADR Index has delivered lower returns with higher risk compared to the MSCI-Australia Index over the full period, irrespective of whether the currency exposure has been removed or not. 

What are the Sources of Risk?
Differences in average monthly return and average monthly risk of these portfolios are decomposed and attributed to two primary sources shown in Figure 2.  We label these as Diversification Gap and Currency Gap.

The annual return of the ADR Index is 3.2% lower than the unhedged MSCI-Australia Index, while the risk is 1.4% higher. As currency movements have been removed from the unhedged MSCI-Australia Index, the source of these variations is due to the differences in the composition of the ADR portfolio and the unhedged MSCI-Australia Index portfolio. Hence, we call this the Diversification Gap.

The extent of the Diversification Gap in the ADR Index can be traced by comparing the industry weights in the ADR Index to those in the MSCI-Australia, as presented in Table 3. In June 2004, the three largest deviations occur in the following sectors: materials (10.6%), telecommunications (9.0%), and financials (7.0%). Interestingly, there is not a single ADR representing Australian real estate or insurance companies in the ADR Index. However, the real estate and insurance segments account for 15% of MSCI-Australia Index residing within its financials sector.

The unhedged MSCI-Australia Index has an annual return which exceeds that of the hedged MSCI-Australia Index by 2.8% while having an incremental risk of 7.3%. This variation is directly related to currency exposure, and is labelled as Currency Gap in Figure 2. During the six-year period studied, currency exposure has resulted in a higher return and higher risk for US investors with unhedged Australian equities.

The combined effect of the Diversification and Currency Gaps on the ADR Index (relative to the hedged MSCI-Australia Index) shows a reduction in return of 0.4% and an increase in risk of 8.7%.

In Figure 1, we observe three distinct periods in terms of relative performance of the portfolios examined. The first period lasts until mid-2000, and is characterised by the outperformance in the cumulative returns of the ADR Index compared to the local hedged and unhedged indexes. This period has stable exchange rates as evidenced by the similarity in the returns from the hedged and unhedged MSCI-Australia Indexes, and so the return difference is attributable to the Diversification Gap. The second regime, however, running from mid-2000 to early 2002, is characterised by an appreciating US dollar against the Australian dollar.  As a result, the cumulative return of the hedged MSCI-Australia Index exceeds both the ADR Index and the unhedged MSCI-Australia Index over much of the period. The difference in performance during this time can therefore be interpreted as arising from the Currency Gap. During the third period, which begins in late 2002, the unhedged MSCI-Australia Index yields the highest return. Relatively large variation in the performance among the three indexes highlights the influence of the Combined Gap during this period.

Summary
US investors seeking international diversification using an ADR Index face several sources of risk.  These include currency risk due to adverse currency movement, as well as diversification risk arising from the inadequate representation of foreign shares in the ADR Index. However, for the knowledgeable investor with a grasp of the risks involved, ADRs and ADR Indexes may nevertheless provide a convenient avenue of achieving international exposure without many of the difficulties inherent in direct investing in overseas markets.

This material is for your private information. It does not contain any specific performance information relating to any particular client investment account. Accordingly, the performance shown does not reflect any fees to which an actual investment account would be subject. The general performance of the unmanaged index shown is based on data developed by third parties and may be subject to revision.  Past performance is no guarantee of future results. The MSCI Index names are trademarks of Morgan Stanley Capital International

The views expressed are the views of VT Alaganar only through the period ended August 27, 2004 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Posted On: September 14, 2004