Abstract
Diversification is a costly process. However, regardless of its costliness, most investors give preference to international diversification of their portfolios due to the potential benefits of similar decisions. Still, there are different tools for diversifying foreign investment portfolios. However, the paper at hand will focus on one of the – American Depositary Receipts or ADRs. In simple terms, these are stocks of foreign companies available on the stock exchanges operating in the United States.
They are commonly invested in due to a variety of benefits, including options for decreased barriers to injecting funds in foreign companies, entering developing and developed markets, timely dividends and corporate action notifications, purchasing and selling foreign stocks easily, etc. Therefore, the objective of the given report is to study the benefits of ADRs mentioned above in detail, describe some other advantages, and make an attempt to explain what makes this diversification tool so attractive with the special focus on economic fundamentals of the countries issuing them.
Introduction
As the national economies become more open and interconnected, the borders between states are becoming nearly transparent. It is true for almost all areas of international economic relations, and investment is not an exception to the overall rule. Deeper integration of the global economy is connected to the emergence of the international platform for investments. With the increased bonds between states, national investors began searching for options of injecting funds in foreign companies without leaving their countries.
The very process of investing in different organizations is referred to as diversification of investment portfolios. It has become especially popular over the last several decades (Pleven, 2014). However, regardless of its popularity, diversification is associated with increased costs. Still, even though it is a costly process, most investors are interested in taking this step, as they count for potential benefits of diversification.
Nowadays, there are different approaches to diversification and investors deploy varying tools for maximizing its benefits. One of these tools is known as American Depositary Receipts. They are commonly referred to as ADRs. Putting it simply, ADRs stand for stocks issued by foreign companies. However, these stocks are easily available on the stock exchanges operating in the United States. It means that even though purchasing them is perceived as foreign investment, there is no actual need for national investors to leave their countries to complete these operations. This diversification instrument is popular regardless of the developments in the stock market.
It can be explained by a variety of benefits. Here, it is essential to point to the fact that ADRs are beneficial for both investors and companies issuing them. For investors, injecting funds in American Depositary Receipts is associated with easier access to the foreign market, decreased barriers to allocating capital in the foreign business environment, improved performance of investment portfolios, timely dividends, and corporate action notifications, purchasing and selling foreign stocks easily, etc.
As for the companies and countries issuing them, ADRs are connected with the increased inflow of foreign investment in national economies as well as the increased value of companies listed on the United States stock exchanges and visibility in both regional and global economy. Therefore, the paper at hand aims at studying the abovementioned benefits in detail.
Search Methodology
To identify the main benefits of ADRs as an international diversification instrument, a comprehensive literature search was conducted via Google search engine and search engines of different databases, including ProQuest, Google Scholar, and EBSCOhost. The main search request was “benefits of ADRs for international diversification of investment portfolios.” To make the research findings more comprehensive, different sources were included: articles published in peer-reviewed journals as well as business and finance magazines and materials available online. There were only two inclusion criteria: relevance of information and date of publication – within the last five years. Primary research findings can be found in Table A1 (see Appendix A).
Benefits of ADRs as a Diversification Tool for Investors
Greater Access to Foreign Markets and Companies
Even though the United States is one of the leaders in the global economy, it does not necessarily mean that all of the most powerful and influential companies operating in the American environment. Instead, ten most attractive firms are non-American (Crimmins, 2017). It points to the need for seeking ways to purchase their stocks. However, it is essential to note that diversification with ADRs is not related to investing in economic giants only.
In this case, the only aspect of ADRs that matters is an opportunity to reach any market and any company of interest regardless of the level of its development or prospects of future growth. More than that, in the case of investing in ADRs, barriers to purchasing foreign stocks are eliminated because there is no need for conducting trading operations abroad (Hales & Diaz, 2015).
Improved Performance of Investment Portfolios
Diversification by investing in ADRs is commonly connected to the improved performance of investment portfolios (Didia, 2015). It can be explained by pointing to two arguments. First of all, stocks of U.S.-listed foreign companies are usually cheaper than those of the American firms. They are not overpriced like in the case of most American companies. It means that investors may purchase greater quantities of stocks while allocating the same volume of capital.
More than that, including different ADRs in a portfolio, is related to increased returns of the purchased stocks, especially if they are issued by a fast-developing company operating in a country with a stable macroeconomic environment (Steverman, 2014). When combined, these two specificities help to improve the overall performance of the investment portfolio so that its owner enjoys higher profits, especially when there are no barriers to selling stocks at any time wanted because they are listed in the U.S. stock market.
No Complex Procedures in Selling and Purchasing Foreign Stocks
To understand this benefit, it is essential to keep in mind that stock markets in different areas of the globe operate under different trading patterns. It means that diversifying portfolios with ADRs listed on the United States stock exchanges are associated with decreased risks of failing to understand country-specific regulations. It can be explained by the fact that all ADRs purchased and sold in the U.S. are traded under the national legal provisions so that all complicated procedures are avoided (Crimmins, 2017). From this perspective, investing in ADRs is related to clear procedures and avoiding risks of increased protection against foreign investors compared to purchasing stocks in the foreign stock exchanges (Hales & Diaz, 2015).
Timely Dividends and Corporate Action Notifications
This benefit is inseparable from the abovementioned one because ADRs are traded under the provisions of the United States legislation. For this reason, companies listing their stocks on U.S. stock exchanges are obliged to pay dividends and provide corporate notification in time, i.e. operate under the domestic rules of the host country. It means that risks and barriers deriving from purchasing stocks of foreign companies on foreign stock markets are minimal (Hales & Diaz, 2015).
Increasing Rewards for Risk
Diversification of investment portfolios is not only a costly but also risky process because there is no guarantee that purchased stocks will be profitable. In this way, lower spending on diversifying portfolios is associated with increased rewards for risks, especially if ADRs and U.S. companies’ stock are at the same profitability levels (Yuan, Gupta, & Roca, 2016). More than that, there are as well options for gaining significant short-term income, especially from speculation.
What is even more significant, owning ADRs is not perceived as owning foreign securities. This specificity of the investigated diversification instrument points to its value in reducing administrative risks deriving from failing to follow particular legal provisions of foreign markets or procedures of becoming a foreign investor (Zhang, 2013).
Decreased Risks Connected to Negative National Developments
The most significant benefit of investing in ADRs is an opportunity to avoid the negative influence of economic downturns in the national business environment. However, to maximize this benefit, it is critical to invest in developed markets. It means that the value of ADRs is directly connected to the economic determinants of the countries issuing them. These measurements include economic growth rate, gross domestic product per capita, inflation, per capita income, and changes in exchange rates. Also, the level of regulatory effectiveness, market size, market liquidity, and private sector development should as well be taken into consideration.
In this way, purchasing ADRs issued in developed states is connected to the prospects of increased stability even in cases of emerging national economic crises, while investing in ADRs of less developed states may be related to even higher risks of volatility and decrease in the performance of investment portfolio (Schaub, 2013). From the perspective of the abovementioned criteria, developed states are not only those with high economic development rates and low annual inflation rates but also those without drastic drops in the operation of the domestic business environment or those constantly improving, even if improvement pace is slow (Hales & Diaz, 2015).
Benefits for Companies and Countries Issuing ADRs
Because ADRs are associated with benefits for investors, it is essential to understand why foreign countries make decisions to become listed on the U.S. stock exchanges and issue ADRs. It is imperative for understanding how the background of the home country impacts benefits connected to international diversification in ADRs.
Increased Inflow of Foreign Investments in National Economies
Issuing ADRs is inseparable for the potential growth of foreign investments in national economies. It is beneficial for the growth of companies and improving their position in the regional and global economy. More than that, it affects the overall development of the national economy. As a result, the decision to issue ADRs is what makes a state more influential and helps investors investing in ADRs on these particular states avoid detrimental consequences of economic downturns in their domestic economies.
Increased Visibility in Regional and Global Economy and Value of Stocks
The first motivation of countries and companies to issue ADRs is inseparable from two more benefits – the increased value of stocks and visibility at both regional and global levels. Both of them are associated with becoming visible in the U.S. stock market. In the long run, it leads to making foreign companies similar to those operating in the United States and contributes to the transformation of economies from planned to market. It means that, over time, it may as well lead to the increased benefits for investors who later allocate funds in the developing countries (Zhang, 2013).
Conclusion
ADRs are a common diversification instrument. Based on the facts mentioned above, it is evident that international diversification of investment portfolios in ADRs is beneficial for both national investors and companies and countries issuing them. However, to maximize the benefits mentioned above, it is imperative to pay special attention to allocating funds in different ADRs as well as lay stress on studying the specificities of the business environment of countries of ADR origin.
From this perspective, to avoid significant risks, it is critical to focus on the macroeconomic development of a particular economy because it is directly associated with the scope of ADRs-related benefits. Still, it is paramount to keep in mind that this process is cyclical because, at first, investors inject funds in ADRs and help foreign companies grow and develop, and over time, they reap the abovementioned benefits.
References
Crimmins, D. (2017). What? You’re not invested in foreign stocks? Why you should be, and how to do it. Forbes. Web.
Didia, D. O. (2015). Emerging markets, American Depositary Receipts, and international diversification. Journal of International Business and Economics, 3(2), 43-50. Web.
Hales, A. D, & Diaz, V. (2015). Issuing level II versus level III ADRS: Do country characteristics matter? Journal of International Business Research, 14(2), 67-74.
Pleven. L. (2014). The right way to invest globally. The Wall Street Journal. Web.
Schaub, M. (2013). Diversification benefits of investing in NYSE-listed developed markets ADRs: Evidence from 1990 through 2009. The Journal of Investing, 22(3), 66-73. Web.
Steverman, B. (2014). Why U.S. investors are buying foreign stocks?Bloomberg. Web.
Yuan, T., Gupta, R., & Roca, E. (2016). Why not diversify into emerging equity markets via ADRs? The Journal of Investing, 25(2), 18-27. Web.
Zhang, J. (2013). Possible benefits of ADR issuance: Evidence from developing countries. Web.