Diversification Potential of ADRs, Country Funds, and Underlying Stocks Across Economic Conditions

Abstract

We study the relative diversification potential of American Depository Receipts (ADRs) as compared to the underlying shares as well as the relative diversification potential of closed-end country funds as compared to the foreign market indexes across various economic conditions. We find that, based on daily return correlations, direct access to foreign stocks is most advantageous in bad times. Specifically, we construct several measures of the U.S. stock market’s and the U.S. economy’s effect on the benefits of including ADRs and country funds in equity portfolios. For all measures, we find that the underlying shares are more useful for diversification purposes than ADRs and country funds when the U.S. stock market returns are low and when the U.S. economy is underperforming. However, there is no evidence of differential benefits of relative diversification when we examine measures based on monthly Sharpe ratios. We discuss potential reasons for the discrepancies between our correlation-based and Sharpe ratio-based results, and conclude that direct access to foreign markets is most valuable in periods of greatest need.