Diversification gains from American depositary receipts and foreign equities: evidence from Australian stocks

Abstract

We investigate the relative advantages of American depositary receipts (ADRs), the underlying Australian stocks and the Australian equity index for a US investor seeking international diversification. We find that the ADR market is priced efficiently that the ‘law of one price’ holds. However, ADRs have an economically significant higher reward/risk ratio than underlying stocks, partly due to lower transactions cost. ADRs have a low correlation with the US market under high states of global and regional shocks. Portfolio managers could use the ADRs directly in enhanced indexing strategies. The dominant information flow is found to occur from the underlying stocks to the ADRs, while at the aggregate level the information flow is primarily from the US to the Australian market.