The prudent investor looks for a more diversified opportunity set with a fuller menu of global equity exposures to capture the different rhythm of mature, developed markets and tap into the growth premium of rapidly developing emerging markets. A Deutsche Bank Trust Company Americas white paper notes that the correlation between the S&P 500 and international markets over the past four years stood, on average, at 0.55%, suggesting that there is a strong benefit in looking beyond the U.S. market as the main diversifier of equity portfolios, since most of these markets have also outperformed U.S. markets.
How best to go global? Canada’s largest pension fund managers—the Ontario Teachers’ Pension Plan, the Canada Pension Plan Investment Board, the Caisse de dépôt et placement du Québec—all have trading desks and can trade, or arrange to trade, through a broker and a far-flung network of agents across different stock markets. New forms of electronic trading are linking markets together, and indeed, some electronic markets are limited to institutional investors trading large blocks of shares among themselves to cut the broker’s or the exchange’s take. But despite all the hype, there is still no integrated global stock trading system.
Instead, global stocks must be approached one at a time. The world’s major marketmakers— the global trading houses with a footprint in each country—can manage this degree of complexity, but many pension funds and sub-advisors lack those capabilities. Of course, they can buy exchange traded funds (ETFs), such as those marketed by Barclays Global Investors or State Street, which represent broad market indexes and are generally used to gain passive exposure. Or they can use American Depositary Receipts (ADRs), which are similar to ETFs and can also be bundled as ETFs.
ADRs package up a tranche of securities traded on foreign markets as securities domiciled in the U.S. The most widely held ADRs include America Movil, BP, Nokia, Royal Dutch Shell, Petroleo Basileiro, Teva Pharmaceuticals, Novartis and GlaxoSmithKline. These are well-known names, and one of them, Compania Rio do Vale, recently scooped up Canada’s blue-chip Inco.
“Depositary receipt trading reached an alltime high at $1.3 trillion for the first half of 2007, up 45% year-on-year and surpassing all of 2006,” notes Edwin Reyes, global product manager of depositary receipts at Deutsche Bank. To put that in perspective, the annual value of trades on the Toronto Stock Exchange is roughly $1 trillion.
ADRs date back to 1927, when JPMorgan first created one for Selfridges, the British retailer. “Basically, it was driven by the sellside community—the brokers,” says Julio Lugo, vice-president at the Bank of New York, one of the major players in the ADR market. “Back then, they found themselves custodizing all these underlying foreign shares. But it wasn’t their core business. They were into buying and selling and investment banking. So they said, what if we can give these ordinary shares to a bank so that they can custodize them as a fiduciary and then deposit a receipt in exchange that represents those foreign shares?”
And that’s essentially how ADRs work. An ADR represents a foreign security that does not trade in the U.S. However, a U.S. depositary bank can issue a receipt for those shares as a brokerage house’s custodian, and they can be traded in various U.S. marketplaces. There are some 2,100 ADRs overall, and they come in different forms. They may be private placements sold to institutional investors. They may be over-the-counter (OTC) securities available to retail and institutional investors alike. In both of these instances, they follow the accounting rules of their home market. Or they may be listed on a public stock exchange, such as the New York Stock Exchange, the American Stock Exchange or the Nasdaq.
Of the total number of ADRs, 450 are listed and 79% of their trading is on the three main exchanges listed above. There are also Global Depositary Receipts (GDRs)—a miniscule category as late as 2000, according to JPMorgan research—which now account for almost half of the capital raised in the depositary receipt market. GDRs trade publicly on European exchanges such as London or Luxembourg and may be listed on a U.S. exchange or held by institutions through a private placement.
There are a number of different reasons for issuing ADRs. For some issuers, they represent an initial public offering to raise capital. For other issuers, it’s a question of raising global brand awareness—recent academic studies suggest that non-U.S. companies get a bump-up in market valuation ranging from 11% to 37% by listing in the U.S.
Beyond pure brand awareness, the reason could be to facilitate a takeover, such as British Petroleum buying up AMOCO and ARCO so that U.S. investors in those companies could receive the takeover price in British Petroleum shares. It could be a vehicle for the privatization of state companies. Or, as in some OTC or private placements, it could simply be a means of getting broader access to capital for company expansion—particularly when there are domestic restrictions on foreign ownership of companies viewed as the bastions of the economy.
“Capital-raising using DRs is on the rise in 2007, dominated by Indian, Russian and Chinese companies,” observes Akbar Poonawala, global head of equity services at Deutsche Bank Trust.
For investors, the ADR structure has other attractions. “By definition, a depositary receipt is a U.S.-dollar-denominated security,” says Lugo. “It trades in the U.S. and all of your information comes in English. What’s the alternative? Well, if I were to buy shares in Russia right now, you have the currency, you have different securities laws, you have to go through a foreign broker, you can’t pull the shares out of Russia; you have to custodize them there. And global custody is much more expensive. Then you have dividends and corporate actions,” such as the issuance of new shares, rights or spin-offs.
In a sense, ADRs are like cross-listed shares—shares listed on multiple exchanges—with which many Canadian investors are familiar. Indeed, there was a time when Canadian cross-listed shares, such as Inco, Alcan and Nortel, were components of the S&P 500, the main gauge of the U.S. stock market. Lugo concedes that worldwide cross-listing would eliminate the ADR market. But this hasn’t happened—for reasons that have less to do with fostering an efficient trading market than with how people take ownership of the shares they’ve bought in foreign markets.
“It’s the settlement aspect,” says Lugo. “If you were to take the U.S./Canadian model and apply it to the rest of the world, there wouldn’t be any ADRs.” And there’s no sign of that changing.
“We can talk about trading: globalization, 24-hour trading, the merging of stock exchanges—you don’t need ADRs anymore. You and I can go Sunday night and pick up the phone, turn on the computer and buy or sell Asian and Australian stocks; we could have done that for the past 20 years. The difference is that you still cannot settle those securities in the United States or in Canada. The ability to move shares across the border electronically and settle those trades—that’s the difference.”
As important as these issues are to pension plans and their fiduciary responsibilities, there is still another issue, and that’s the comprehensiveness of market coverage. There are more than 460 listed ADRs in the U.S. By no means do they represent the world opportunity set of equities, but they’re close enough to what many institutional investors want: easy access to the most liquid stocks in global markets. And there are ADR ETFs—not the total market exposure offered by some companies, which may involve a variety of sampling techniques to minimize the number of illiquid shares owned, but still tracking pretty closely to a third-party index of price levels.
“The ADR tends to be the largest-cap companies, the most well-known, most liquid, most actively traded stocks—after all, if they don’t trade actively in the local market, how can you have them trade in the United States?” says Lugo. “So you get a high replication of indexes.” Replication, however, is not perfect tracking. “We know of several funds that use ADRs and try to benchmark EAFE. EAFE is not an ADR index. You do get a high replication, but the tracking error may be a little more than you like.”
What’s the cost? It depends on how you look at cost: as opportunity cost or as trading and administrative cost. “That’s why ADRs still work; it’s the cost savings,” Lugo says. “And the foreign market for global custody is based on a basis-point fee. As your investments increase in value, which we all hope for, so will your global custody fees.” By contrast, North American custodians charge on a per-item basis, no matter what the value of the holding.
ADRs are an efficient way to gain exposure to the most liquid of international stocks. They are also cost-effective for plan sponsors when it comes to administrative costs. For plan sponsors seeking more foreign exposure, investment consultants can help line them up with the right asset managers.
Scot Blythe is senior group editor with the Advisor Group and editor of Advisor’s Edge Report. scot.blythe@advisor.rogers.com
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