Foreign Markets Using ADRs

Summary Points

• Using foreign stocks to complement a portfolio of U.S.-based stocks may potentially increase returns and lower volatility over the long term.
• American Depositary Receipts (ADRs) can streamline U.S. investors' access to foreign markets.
• ADRs are listed on major exchanges and are traded like many U.S.-based stocks.

American Depositary Receipts, ADRs for short, represent some of the most familiar names in global business, including companies that are so deeply integrated into the American economy that they are included in the S&P 500. One such ADR is Royal Dutch Petroleum, maker of Shell gasoline. Another is Unilever, whose consumer brands include Lipton tea, Hellmann's mayonnaise and Dove soap. Understanding ADRs can help you build an investment portfolio with stronger average returns and lower overall variability.

Investing Overseas Can Help Diversify a Portfolio

The potential benefit of global investment has tantalized investors for decades. A portfolio whose holdings are diversified across national borders may have lower overall volatility and higher average returns than a collection of investments in any single economy. For a U.S.-based investor, that benefit can be clear even when small amounts of the assets are foreign.

For example, a portfolio with 80% of its assets mirroring the S&P 500 and 20% mirroring the Morgan Stanley Capital International EAFE Index of developed foreign markets would have produced an annualized total return of 10.04% since 1970, compared with an annualized total return of 9.83% for the S&P 500 alone. The globally diversified portfolio was less volatile as well; so its risk/reward ratio was 0.60, compared with 0.58 for the S&P 500 alone.¹

Depositary Receipts Can Simplify Access to Foreign Markets…

ADRs are a form of equity security that was created specifically to simplify foreign investing for American investors. An ADR is issued by an American bank or broker. It represents one or more shares of foreign-company stock held by that bank in the home stock market of the foreign company. (The ratio of foreign shares to one ADR will vary from company to company, but each ADR for any one company will represent the same number of shares.)

ADRs may be listed on the New York Stock Exchange, American Stock Exchange or Nasdaq. Those that are listed can be traded, settled and held as if they were ordinary shares of U.S.-based companies. ADR investors are not subject to non-U.S. stock transaction taxes. And for those countries that maintain tax treaties with the U.S., dividends are paid without foreign withholding. However, like investment gains or income from domestic securities, proceeds from an ADR holding may be subject to U.S. income or capital gains taxes and may be subject to backup withholding.

Foreign companies that sponsor listed ADR programs in the U.S. issue financial reports in English, and these reports generally conform to U.S. accounting conventions. These companies also file required disclosure statements with the Securities and Exchange Commission (SEC).

Companies that meet all U.S. reporting and disclosure rules are permitted to raise capital directly from U.S. investors by issuing new stock specifically to be represented by ADRs. Companies that meet a more limited set of SEC reporting requirements are permitted only to sponsor ADRs that represent shares previously issued in their home markets.

In rare cases, a U.S. bank or broker may create an ADR without the support of the company that issued the underlying stock. However, these securities, referred to as unsponsored ADRs, cannot be offered for sale to individual investors in the U.S. unless the foreign company files appropriate financial reports with the Securities and Exchange Commission or requests an exemption under Section 12g3-2(b). The SEC maintains a list of all 12g3-2(b)-qualified companies.

...And Still Offer Investors the Potential Benefits of Diversification

Studies suggest that ADR prices tend to behave like the underlying stocks of the foreign companies they represent, rather than like the domestic U.S. stocks alongside which they trade. For example, one study that compared the prices of ADRs with the prices of their underlying shares concluded that any price differences between the U.S. and home market are more likely the result of currency effects than market inefficiency.

And what's more, ADRs may give U.S. investors a more favorable reward-to-risk ratio, due to lower transaction costs.² Another study looked at the impact of market shocks on ADR prices and concluded that any effects tend to disappear for long-term investors.³

Studies such as these indicate that the potential benefits of global stock market diversification can be readily realized through familiar resources.