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### May 24, 2018 | Global/Emerging Markets

American Depositary Receipts (ADRs) are a relatively cost-effective way to gain international equity exposure for investors seeking to diversify portfolio exposure beyond U.S. companies. There has been significant growth in the ADR market over the past year, but investors should be mindful of transparency, liquidity, and currency risk when navigating the expanded universe.

The Basics

ADRs are U.S. dollar-denominated securities that trade in the United States, but represent shares of foreign corporations.

Developed to minimize the complexities involved in buying international equities, ADRs provide potential cost savings for U.S. investors through reduced administrative fees and the avoidance of foreign taxes on individual transactions.

The ADR market has been growing, thanks to increased issuance and accessibility.

Depositary receipt capital-raising activity in 2017 rebounded significantly from 2016, according to Citi's Depositary Receipt Services Year-End 2017 Report. Foreign issuers raised $15.6 billion via depositary receipts in 2017, up 126% from the previous year, with Chinese companies leading activity. The growth of the ADR universe creates more investment opportunities, but there are risks to bear in mind with respect to different ADR structures. Many investors believe that ADRs avoid foreign currency risk because they are denominated in U.S. dollars, which is not true. Sponsored ADRs—which are created when a U.S. depositary bank works with a foreign company to purchase its shares, bundle the shares, and reissue them—are subject to regulatory oversight and trade on major stock exchanges. Unsponsored ADRs, on the other hand, are created without the cooperation of a foreign company by broker-dealers who want to trade the foreign company's shares. These ADRs have significantly less regulatory oversight and only trade over the counter (OTC). It's important to be mindful of the different types of ADRs with respect to transparency and risk management. Transparency Sponsored ADRs referred to as level II and level III are subject to all registration and reporting requirements imposed by the U.S. Securities and Exchange commission, and come with significant transparency as a result. Level I sponsored ADRs, which are originated by foreign companies that want to offer shares inexpensively, have more limited regulatory oversight and transparency. Thus, we tend to focus on level II and level III sponsored ADRs. Liquidity Risk Liquidity is another important consideration for us. When investing in ADRs, we focus on those with higher liquidity. Level II and level III sponsored ADRs, for example, can be listed on major U.S. stock exchanges such as the New York Stock Exchange or the Nasdaq, and they are generally more liquid as a result. We will also occasionally invest in level I ADRs, which are only traded on the OTC market, if we are confident in the liquidity profile based on historical trading activity. Another risk ADR investors should consider is the potential for ADR issuers to delist from major stock exchanges and move to the OTC market. During the 2008 financial crisis, for example, a number of ADRs were abruptly delisted, creating liquidity issues. We own ADRs with relatively higher trading volumes to help mitigate overall portfolio liquidity risk, as we believe that larger, more liquid ADRs help dampen volatility. Currency Risk Many investors believe that ADRs avoid foreign currency risk because they are denominated in U.S. dollars, which is not true. ADR prices are indeed adjusted to account for underlying foreign currency movements. For example, if an ADR for a U.K.-domiciled company is trading at$100 and the British pound depreciates by 2% versus the U.S. dollar, the ADR price will adjust downward by 2%.

ADR portfolio managers have the option to hedge currency exposure to protect against foreign currency depreciation. If the dollar is strengthening, for example, he or she could short the foreign currency and go long the dollar.

We take a more nuanced, company-specific view of currency risk in building our portfolios. Our research analysts are tasked with understanding the underlying revenue and cost exposures across different geographies and currencies for every company we invest in. Underlying currency hedging activity is also assessed for each company.

From a broad perspective, one can generalize that if economic growth and inflation are trending higher, and a company's revenues are expanding, there will naturally be an upward bias in the share (ADR) price over time.

The currency market is very different, however, with more variables driving exchange rate movements, including interest-rate differentials and relative trade balances between countries.

Instead of hedging currency exposure, we take a currency view when constructing our portfolio. One example is our positioning in the United Kingdom, where we believe the pound will weaken.

Because of Brexit, there's a great deal of uncertainty about future economic growth prospects and the outlook for the pound.

Thus, most of our U.K. exposure is in companies that are likely to benefit from a weaker pound—for example, a company in the pharmaceutical industry, which is notorious for benefiting from a stronger dollar, and a food service company that generates 40% of its revenue in the U.S. and only about 10% in the United Kingdom.

If the opposite were the case, we would pivot toward companies with a higher percentage of their revenue coming from the United Kingdom, such as banks.

It's important to remember that foreign currency exposure can be a great diversifier for investors with significant U.S. dollar allocations.

We believe that maintaining diversified exposure across different currencies can help to reduce volatility over time.

Why International?

We acknowledge that it is difficult to advocate for ADRs without making a case for non-U.S. (international) equities. This is certainly complicated by the fact that many investors' international equity exposure has underperformed their U.S. equity exposure over the past decade.

Despite its recent rebound, the U.S. dollar has been trending downward since December 2016, which benefits dollar-denominated international equity returns.

That being said, the tide started turning last year. The U.S. is in an interest-rate-tightening cycle, in contrast to other major economies, creating a more positive environment for international equities.

Secondly, despite its recent rebound, the U.S. dollar has been trending downward since December 2016, which benefits dollar-denominated international equity returns.

It is also important to note that there are few “must-have” names in international equity benchmarks, which presents opportunities for active managers.

In the U.S., a handful of must-have stocks, such as Apple and Facebook, dominate market cap-weighted benchmarks. As a result, asset managers are keenly aware of how much exposure they have in these stocks relative to the benchmark.

If a manager maintains a 5% weighting in a core name when the benchmark owns 7%, he or she is taking a significant bet against the stock.

Contrast this with international markets, where the highest positions in the benchmark are typically about 2%, and there is a relative scarcity of must-have companies. In Asia there are approximately two or three of these companies currently, and in Europe there are none.

As a result, we believe that active international managers have a broader opportunity set and are less encumbered by some of the relative position sizing constraints that are inherent in the narrow leadership profile of the U.S. market.

References to specific securities and their issuers are for illustrative purposes only and are not intended as recommendations to purchase or sell such securities. Specific securities described do not represent all of the securities purchased, sold, or recommended for advisory clients. It should not be assumed that any investment in the securities referenced was or will be profitable.

David Merjan, CFA, partner, is a portfolio manager on William Blair's Global Equity team.