The Right Way to Enhance Your Portfolio's Global Diversification

This article is published with permission from InvestmentU.com.

Investing in foreign companies is an effective way to diversify a portfolio, and today many of the most attractive growth opportunities are located outside the US.

Investors looking for global diversification have a number of ways to invest in international equities. They can choose from a multitude of mutual funds invested in international, emerging market, and even frontier market stocks; or they can purchase exchange-traded funds. For the investor focused on individual stock selection—rather than a product based on an overall strategy—there are several options.

The investor can go directly to the market in which the stock is listed—but this is both extremely complicated for the individual investor and presents a higher level of risk. Some foreign stocks are listed in the US, but this is not common.

ADR 101

American depositary receipts (ADRs), either sponsored or—increasingly, in the past 5 years—unsponsored, offer the most effective method for investing in a specific issue.

An ADR is a certificate issued by a depositary bank (BNY Mellon, JPMorgan, Citi or Deutsche Bank) that represents shares in a foreign company held by a custodian (either a local market custodian or the custodian arm of the depositary bank). An ADR may represent one share, multiple shares, or a fraction of a share if the stock is expensive.

A sponsored ADR program is undertaken at the behest of the foreign company, which can enjoy many benefits from such a program. It can raise capital, broaden its investor base, increase international awareness of the company, and boost liquidity.

There are 3 levels of sponsorship, each requiring a higher level of disclosure and reporting. A Level 1 ADR, which can only be traded in the over-the-counter (OTC) market, is not registered with the Securities and Exchange Commission (SEC), and the company has no obligation to conform to generally accepted accounting principles. Level 2 and Level 3 ADRs can be listed on the New York Stock Exchange, the American Stock Exchange, or Nasdaq.

In 2008, the SEC issued a rule change that made it easier to create depositary receipts for non-US, publicly traded companies to trade on the OTC market. This change resulted in an explosion of unsponsored ADRs—1,206 new unsponsored ADRs from 38 countries had come to market by the end of 2012.

Sponsored or unsponsored?

An unsponsored ADR is demand-driven, and created at the behest of the investor who wishes to buy stock in a foreign company that does not trade on US markets. This type of ADR is issued by the depositary bank without the involvement, participation, or consent of the foreign company.

Issuers that participate in sponsored Level 2 and 3 ADR programs, by virtue of the SEC registration requirements, willingly adhere to the reporting and transparency standards that prevail in the US markets, thus mitigating some of the risk of investing in unfamiliar foreign markets.

However, both types of ADRs clear and settle in US dollars.

The risks

Investing in ADRs, sponsored or unsponsored, involves several types of risk in addition to the typical ones associated with equity investments. For example: currency risk. Although the transactions are undertaken in US dollars, the value of the ADR will fluctuate along with the exchange rate between the USD and the currency of the issuing company’s country.

Political risk and regulatory risk can also be an issue. Political instability or corruption can influence ADR prices, while changes in laws and regulations that are negative for investors or the flow of capital could also have a negative impact. Some brokers also charge additional fees on top of regular transaction charges, which can have a negative impact on potential returns.

Unsponsored ADRs carry not only these risks, but the added risk of reduced transparency, as discussed above. Unsponsored ADRs can also be thinly traded, with a wider bid-ask spread. Finally, transaction costs are higher since the ADR is created at the behest of the investor, who must contact a depositary bank directly to arrange the ADR issue if an unsponsored ADR is not already trading.

Today, the number of unsponsored ADRs in the market is higher than ever, and investors can trade 100% of the Hang Seng (Hong Kong), TOPIX 100 (Tokyo), and DAX (Frankfurt) indexes, and more than 90% of the FTSE 100 (London) and CAC 40 (Paris). But with all ADRs, and particularly unsponsored ADRs, the individual investor must be ready to undertake significantly more research before making any investment decision and remain cognizant of the risks involved.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.