As impressive as it was, last year’s 28.9 percent rise in the U.S.'s Standard & Poor’s 500 index couldn’t hold a candle to Australia’s 53.8 percent gain or Sweden’s 66.2 percent ascent. In fact, the S&P 500’s lesser-known cousin, the S&P ADR index, which reflects the returns of 266 foreign stocks, surged 37 percent in 2003. The striking gains have already persuaded more investors to venture abroad. Between January 2003 and January 2004, monthly trading volume of American depository receipts rose steadily, from 2.7 billion to 4.2 billion shares; the value of monthly turnover doubled, to $92 billion.
“We’re clearly seeing growing demand for foreign securities,” says Julio Lugo, vice president of institutional trust services at J.P. Morgan Chase & Co. in New York.
Before rushing into overseas markets, however, investors need to evaluate the best route. There are two basic choices: buying in the local market or, for the reluctant traveler, purchasing ADRs, which are depository receipts of foreign shares that trade on U.S. markets. ADRs and their corresponding foreign shares are convertible into one another. Choosing between them requires an assessment of local market liquidity and pricing, brokerage commissions and fees, custody costs and, recently, taxes.
In large developed markets local shares usually offer superior pricing, says T. Rowe Price International Growth and Income Fund portfolio co-manager Raymond Mills, who keeps about 90 percent of his $194 million directly invested in these bigger overseas bourses. Better pricing, he explains, “comes with significantly higher ordinary trading volumes.”
But the custody costs of holding these shares can be relatively high, because they are calculated as a percentage of asset value. ADRs usually incur a flat annual custody fee of $34 per position.
In emerging markets, conversely, ADRs sometimes offer better pricing than their corresponding ordinary shares because the local stocks are usually more thinly traded; custody fees in these markets are generally higher than the ADR fee.
To get an idea of the variables an investor must consider, compare the respective costs of investing in Russia’s leading tele-communications service provider, Rostelecom, in Moscow and in New York. In early December, ADRs of Rostelecom were trading at about $12. A purchase of $1 million would have cost $5,840, based on a 2 cent per share commission ($1,668) and 5 cent per share ADR creation fee ($4,172). (The latter assumes that there wouldn’t be adequate supply of shares trading in New York to fill the order efficiently, thus requiring a depositary to package new ADRs.)
Going local through a brokerage’s Moscow desk would typically cost the institution a 1 percent brokerage fee, or $10,000, plus 6 basis points, or $600, to convert U.S. dollars into foreign exchange. Buying ordinary shares would cost approximately $4,760 more than purchasing ADRs. With the savings, an ADR investor could have picked up 397 more Rostelecom shares back in December.
The cost disparity on a Russian purchase expands over time. Annual custody fees total $6,500 for the equivalent of $1 million in Russian shares versus $34 for ADRs, regardless of size.
The situation is different in a bigger, more liquid market like the Paris Bourse. Consider the case of Suez, the French utility giant. ADR commissions on
a $1 million investment could run 2 cents per share, or approximately $1,000. The ADR creation fee would add up to $2,500. Total cost of buying Suez ADRs: $3,500.
Buying on the Paris Bourse would be considerably cheaper -- about $2,100. That sum includes a 15-basis-point commission ($1,500) and the 6-basis-point foreign exchange fee of $600. Because the local market is large and liquid, the investor should also get a lower initial price than he would for ADRs.
Still, ordinary shareholders give back part of the savings through higher French custody costs of 3.25 basis points, or $325, for a $1 million holding. This charge would subsequently fluctuate with the value of the investment. The ADR custody fee, on the other hand, would remain a flat $34.
Theodore Miller, director of international investing at Birmingham, Michigan’s World Asset Management, a unit of Munder Capital Management, says he is constantly assessing the cost-effectiveness of his holdings. When custody costs are high or rising, Miller swaps shares into ADRs. “With conversion costs of about 3.5 cents per share,” Miller notes, “long-term investors will see enhanced returns.”
Although ADRs generally trade in line with local shares, they may in certain markets be priced at a premium to their native counterparts because they’re not readily fungible, or exchangeable, into ordinary shares, and vice versa. In India, where there are still limitations on foreign ownership of local stocks, ADRs of name-brand stocks like software maker Infosys trade at big premiums to ordinary share prices (in Infosys’ case, 47 percent). “India continues to be a very challenging place for foreigners to buy and hold local shares,” says Christopher Lively, emerging-markets portfolio manager at Citigroup.
Interestingly, ADRs in several big emerging markets are more liquid than their ordinary counterparts. For example, $70 million worth of Teléfonos de México shares trade daily in the U.S. versus just $15 million in Mexico. And more than $40 million worth of Petróleo Brasileiro stock changes hands in the U.S. versus $33 million in Brazil. Liquidity and more flexible U.S. regulations also favor ADRs when an investor wants to short an emerging-market stock.
Where conversions are readily available, arbitrage keeps pricing between ADRs and local markets fairly tight -- within 50 basis points, on average. Edmund Harriss, who manages $160 million in several Asian funds for London-based Guinness Atkinson Asset Management, says he has traditionally preferred to own the local shares of big companies like HSBC, China Mobile, CNOOC (the Chinese oil concern), and Yanzhou Coal Mining Co. “These local shares are typically more liquid, denominated in the currency to which I want exposure and easy to repatriate,” he says.
While ease of purchase and low holding costs are oft-cited reasons for buying ADRs, William Landers, New York based co-manager of Merrill Lynch’s $600 million Latin America Funds, points out that depositary receipts also prove useful in times of crisis, such as when governments impose capital controls, as Argentina did in 2002. “Being in ADRs enables us to sell out of our investment at any time, because our capital is not technically in the local market.”
In liquid emerging markets, establishing local accounts can be a headache. Nancy Nierman, director of international focus products at Credit Suisse Asset Management in New York, explains that in South Korea, Taiwan and India, each account needs to be segregated because trade settlement procedures are much more complicated than in the U.S. In Taipei, for example, cash needs to be in a foreign account a day before an investment is made.
For institutions that don’t have direct access to local foreign desks, J.P. Morgan’s Lugo points out, ADRs are generally much easier to research in English. “This is assured,” he explains, “because of the existence of a bank depositary relationship and greater U.S. demand for such shares. And just as important, companies with ADRs are required to translate and direct all legal notices and correspondences to U.S. investors.”
There’s one final wrinkle. Last year, after Congress cut dividend tax rates as part of President Bush’s tax package, it looked like ADRs might gain a significant edge over local shares. Many observers believed that only dividends of U.S.-exchange-listed shares would be taxed at the new low rate of 15 percent. But the Treasury Department subsequently specified that ordinary shares and over-the-counter-traded ADRs from countries that have comprehensive tax treaties with the U.S. would also get the tax break. The key markets that lack treaties: Hong Kong, Taiwan, Singapore and Brazil.
In these markets, says Guinness Atkinson’s Harriss, “The tax implications may not readily show up in fund performance numbers. But investors will see an
after-tax difference.” Switching securities, says Harriss, would make a difference for his ChinaHong Kong fund, which is made up entirely of Hong Kong shares whose dividends will continue to be taxed by the U.S. at ordinary income tax rates, more than twice as high as dividend rates for investors in the top tax bracket. “The combination of higher Asian custody fees and the lower U.S. dividend tax rate is now making me consider ADRs when establishing new positions,” he says.
Given the nuances in making this decision, what’s the best way to go? Lugo believes that efficiency should probably trump most investor concerns. “While it’s fine to save 10 basis points here and there,” he explains, “if the trading process is at all impeded by a particular approach, it could cost investors far more than what they may realize from these savings.”
Ultimately, holding both ADRs and ordinaries may make the most sense. Steven Saker, senior investment adviser at Orlando, Floridabased broker-dealer International Assets Advisory, believes a balanced approach would significantly expand the hours in which shares could be traded and help diversify order flow so large trades don’t affect pricing. Holding both share types, says Saker, mitigates the risk of getting blindsided by an unexpected local market policy change. Exercising caution is usually wise when traveling.
