The Superiority of ADRs over Country Funds as a Tool for International Diversification

Abstract

This study evaluates the appropriateness of country funds versus American Depository Receipts (ADRs) for international diversification for small domestic investors. During the past decade as more country funds have become available small domestic investors have embraced these funds as a tool for international diversification. During this same time period more and more ADRs are available but have been largely ignored by these same investors. This study shows that investors holding a diversified portfolio of ADRs would have realized a higher relative return on their investment than the same dollar investment in closed-end indexed country funds. A portfolio of all available ADRs from a specific country (i.e. ADR index) should provide similar returns to an indexed country fund. But ADRs offer distinct advantages over country funds. Because the ADRs have fewer costs associated with ownership this study proves that the advantages of ADRs over country funds make them a superior international investment for the small domestic investor. First, country funds trade at a discount to NAV and have liquidity issues that create a downward bias in absolute returns. This downward bias contributed to every individual country ADR index in our study earning higher average returns over the comparable country fund during the same investment time period. Secondly, the correlation with the S&P 500 Index is in most cases lower for the individual country ADR index versus the specific country fund. Hence the benefits of diversification are better with ADRs. Thirdly, ADRs are individual stock issues so there is no management fee. And, finally, ADRs as individual stock issues can be bought and sold as deemed appropriate by the investor hence all tax implications (capital gains and losses) are determined by the direct actions of the investor as opposed to the actions of the fund manager.