Risk and Return Characteristics of American Depository Receipts

Abstract

I nvestors able to buy and hold the New York Stock Exchange (NYSE) composite index would have earned a before-tax average annual return of 7.7% (without dividends) over the period 1972-1990. Investors able to buy and hold Morgan Stanley Capital International's Europe, Australia, and Far East (EAFE) index, by contrast, would have earned a before-tax average annual return of 13.5%. Replicating the EAFE index, however, would have exposed the holder to greater risk. The standard deviations of annual returns for this period were 16.9% and 24.4% for the NYSE and EAFE index, respectively. Because correlations between international equity markets are less than one, favorable and unfavorable events have offsetting impacts, and international investment leads to less rather than more portfolio risk (see Brinson and Carr [1989], Grubel [1968], Lessard [1973], Solnik [1974], and Solnik and Noetzlin [1982], for example). Reduction in systematic risk is partially offset by new risk exposures on both the macroand microeconomic level, with attendant ramifications for investor wealth. For example, recent events in Mexico such as the Chiapas Rebellion in January 1994 and the foreign currency devaluation in December contributed to a 50.6% decline in the value of the Mexican stock exchange index. Increased risk is not confined to emerging markets, however. Developed countries such as Sweden, Italy, Spain, and Canada face large fiscal imbalances, and Germany continues its struggle with reunification while being haunted by the specter of neo-Nazism. Hence, an assessment of general risks confronting international investors is both important and topical. One major problem to examining this issue empirically is the cost of acquiring data. Fortunately, we do have data for American depository receipts. American depository receipts (ADRs) are dollar-denominated, negotiable instruments issued by a depository bank to represent ownership of a foreign security in the bank's possession. ADRs supposedly offer investors an opportunity to invest globally without many of the risks and administrative problems associated with direct foreign investment. While Officer and Hoffineister [1987] have shown that portfolios comprising both domestic common stocks and ADRs provide risk-reducing benefits, no study has examined the other risks that arise from diversifying internationally. Presumably, risks associated with investing in emerging markets such as Mexico should be greater than risks of investing in developed markets, but the limited data on emerging market securities preclude a more complete examination at this time. Hence, this study focuses on examining risks associated with ADRs from developed countries. The evidence is that ADRs outperformed their respective home-country index for thirteen of the sixteen markets studied between January 1988 and January 1993. This superior performance appears to be time period-dependent and, at least to some extent, a consequence of foreign currency appreciation relative to the dollar. The study also shows that NYSE-listed ADRs are less liquid, as measured by the bid-ask spread, than a control