Journal of Emerging Market Finance

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International Portfolio Diversification: A Comparison of ADRs and Closed-End Country Funds

Thomas S. Coe Journal of Emerging Market Finance 2002 1: 31 DOI: 10.1177/097265270200100103 The online version of this article can be found at: http://emf.sagepub.com/content/1/1/31

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International Portfolio Diversification: A Comparison of ADRs and Closed-End Country Funds

Thomas S. Coe

portfolios through

Individual investors in the United States may globally diversify their the purchase of shares of individual corporations, by

investing in American Depository Receipts (ADRs) or the pooling of funds in investment companies, particularly closed-end country funds. This article
summarises the performance of both of these types of investments over the period from January 1990 through December 1999. For the period studied, a greater proportion of naively traded, country-specificADR portfolios show better risk-adjusted returns than do the corresponding professionally managed country funds.

1. Introduction

US investors have had access to the tools that have made international portfolio diversification possible, these tools have had limited benefit prior to the last decade. The access to international markets is possible through the purchase, directly or indirectly, of shares of corporations that trade on non-US exchanges. These are primarily available in the US as American Depository Receipts (ADRs). American Depository Receipts are securities representing actual shares of foreign corporations that are deposited in a few large US commercial banks. The ADR allows US investors to invest in these foreign corporations but through US markets and trading firms, trade

Although

Acknowledgements: The author acknowledges the helpful comments of the editors, an anonymous referee, as well as Nicole Garibaldi and the participants at the Academy of Financial Services 2000 Annual Meeting.

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32

in US dollars instead of the local currency of the foreign corporation, and receive more information regarding the investment than would be available by investing directly in the foreign markets. Prior to the last decade, most ADRs were of companies from developed economies. Shares of corporations located in emerging economies were primarily limited to investment funds, either open or closedend. Due to restrictions on foreign ownership of shares, many countries did not allow for direct purchase of shares or the sponsoring of ADRs. Country funds (as well as regional and international funds) allow for investors to diversify internationally by investing directly with an investment company that is either an open-end (mutual) fund, or a closed-end fund. The basic difference between the two is that closedend funds have a fixed number of shares issued and outstanding and trade on the US exchanges. The investment companies that operate these funds are located in the US, but have trading operations located in the host country of the fund, and so in essence are the same as any domestic fund, but market to US investors. The funds invest directly in the securities of the host country and transact in the currency of that country. This trading is not transparent to US investors since trading of the country funds is also in US dollars. Many of the legal and economic restrictions of the international financial markets have changed during the last decade. As a result of the general bull market, primarily seen in the US and other western countries, more corporations have sought access to this greater pool of financing. Many countries have liberalised their financial markets and have allowed for greater access to their exchanges and to the ownership of shares of their corporations. The opening of former centralised economies and the privatisation of former state-owned businesses have made the public ownership and trading of more corporateshares possible. However, the last decade has seen many of the risks associated with foreign investing which have been well chronicled. Many international bourses witnessed stock manipulations and trading scandals. The earlier debt crisis that affected Mexico (Bailey et al. 2000) and Latin America and the Asian (Far Eastern Economic Review 1997-99; Brealey 1999) and Latin American (Chen et al. 2002) economic crises gave reason to avoid internationalising investments (Mauro et al. 2002), especially in light of the continued rise in the US market. Despite the risks inherent to equity trading, and international equity trading in particular, it is still necessary for investors to maintain

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diversified portfolios and reconsider international diversification. Table 1 shows the average total returns of ADRs and Table 2 shows the total returns of closed-end country funds from the countries that have both ADRs and closed-end country funds trading on US exchanges. The returns for each country show that the passive investment (buy and hold strategy) in ADRs as they come to market often exceeds the returns provided by country funds, which tend to hold many of these same ADRs. In fact, many countries show average ADR returns that are positive, whereas the country fund shows negative results. This article will add to the body of literature that shows the benefits of international portfolio diversification. The emphasis will be
Table 1

Comparison of Total Returns for ADRs over the Period 1990-99

Notes: The

Holding Period returns for the ADRs of each country are shown for the period. The returns are calculated using the dividend-adjusted closing prices from each securitys first trading day through 31 December 1999.

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34/ Table 2

Comparison of Total Returns for Closed-end Country Funds

over

the Period 1990-99

Notes: The Holding Period returns for the underlying Closed-end Country Fund(s) of each country are shown for the period. The returns are calculated using the dividend-adjusted closing prices from each funds first trading day through
31 December 1999.

the potential trading performance of individuallyconstructed country portfolios to that of professionally-traded country funds. By constructing an ADR-based portfolio for each country and
on

contrasting

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performance to that of a closed-end country fund, it possible for individual investors to mimic the returns of professional fund managers. The balance of the article is as follows:
comparing
should be
its

section 2 reviews the relevant literature that supports this line of research ; section 3 describes the data and the methodology employed; section 4 discusses the results of the research; and section 5 concludes.
2. Relevant Research

The existing literature has developed from Levy and Sarnat (1970) in their comparison of returns of international markets and the US domestic market. The diversification benefits of international investing stem from the lower correlation of returns of international markets compared to strictly investing within the US market. Officer and Hoffmeister (1987) provide a comparison to strictly domestic investing by constructing a portfolio of 45 ADRs. While the ADR portfolio had a higher degree of risk than the domestic portfolio, the combined global portfolio was shown to be more efficient. The high correlation of returns around the economic effects of currency and financial crises of the 1990s led to an increased risk premium for bonds, as found by Mauro et al. (2002). The higher returns for debt would correspondingly lead to higher risk premia for equities. This should be seen through higher standard deviations or betas when measuring the total risk as well as the systematic risk of the international investments. Bailey and Lim (1992), Johnson et al. (1993) and Coe (1999) find that closed-end country funds do not necessarily have similar returns as the international markets they represent. Although country funds provide for diversification against the US market, investors may not be getting comparable returns as expected by the performance of the actual international market. This is due to the effects that US market influences have on the trading performance. Since funds trade in the US, the funds tend to be affected more by the relative movements of the US market and not as much by the representative foreign market. Recently, international index funds have become more widely available for portfolio diversification. The performance of passively managed index funds is superior to that of actively managed funds, such as closedend country funds. The comparison of index funds and actively managed mutual funds are studied by Gruber (1996), and supported in the

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international context by Aiello and Chieffe (1999). Although international index fund investments have not outperformed the US market, the benefits of diversification and also of lower management costs make these types of investments attractive. Index funds popularity stems from the general perception (Strong 2001) of underperformance by professional fund managers who actively trade the assets of the fund. This, plus the added expenses and management fees of investment funds, would lead to an a priori expectation of an index fund outperforming a professionally managed fund. While this study doesnt include the index fund as a potential investment (being done so in Aiello and Chieffe [1999]), the passive buy-and-hold strategy described below for the individual investor trading in ADRs would be expected to have a similar, better performance compared to country funds, particularly in periods of upward-trending markets. Another explanation for the potential difference in performance between country funds and ADR trading is offered by Bonser-Neal et al. (1990), As markets liberalise and make available new investment opportunities, the premium on country fund net asset value (hence the price) is reduced. Some proof of this would be seen in the performance in portfolios of South Korea and Taiwan, which previously restricted foreign access to fund investing. For the many studies that have investigated international investments, only Bailey et al. (2000), concerning Mexican and Latin American investments as a result of the 1994 peso devaluation, have made any direct comparison between the performance of ADR and country fund trading. This article will provide evidence of such a comparison on a more extended sample and time period.
3. Data and

Methodology

This article uses two samples. The first sample consists of 228 actively traded ADRs that traded as of 31 December 1999. The sample was drawn from issues reported through Bloombergs ADR Monitor, and cross-checked with those ADRs issued through J.P. Morgan. This sample was limited to those 23 countries that also have a closed-end country fund trading as of 31 December 1999. This latter sample results in 33 country funds. Monthly closing prices (adjusted for any dividends paid) were used to calculate returns. The closed-end country fund for each country most likely includes in its holdings many of the same underlying equities that trade as ADRs,

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since these corporations tend to be the larger, more widely traded equities of the country. In that regard, an investor would not necessarily hold a portfolio both of a countrys closed-end fund as well as the separate ADRs due to the potentially high correlation of returns, which would negate any diversification benefits. This article attempts to mimic an ADR portfolio that will substitute for the professionally managed closed-end fund to see if individual investors can earn similar or better
rates

of return.

I 3.1 Construction of ADR

portfolio

A portfolio of each country is made up of the ADRs as they list on the US market. Since individual ADRs were not all listed as of 1 January

1990, the proportion invested in each would decrease to reflect the addition to the portfolio of a new holding. The portfolio is equally weighted amongst the n ADRs as of 31 December 1999. An illustration of this is the Philippines, where there is only one ADR actively traded (PHI-Philippine Long Distance Telephone). As another Filipino ADR is included, the portfolio will be equally split between PHI and that ADR, and so on. The returns of the portfolio are time-weighted to reflect the longer price history for those more seasoned holdings. In this article, there are a few countries that list the same number of ADRs, but would have different portfolio weights invested in each, due to the time each ADR came to market. The returns for each ADR are calculated as

The

returns can

be written in matrix form

as

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38//

The portfolio weights

are

given as

where R is the column vector made up of the separate returns of the n ADRs and W is the column vector of the time-weighted proportion ultimately invested in the n ADRs that comprise a countrys portfolio. The portfolio returns are found as

In similar manner, the risk of the deviation, is found as

portfolio, measured by its standard

where r is the variance-covariance matrix of the

ADRs,

3.2 Evaluation

measures

The country ADR portfolio and the closed-end country fund are compared for their relative performance based on return and standard deviation. In addition, the performance is contrasted to that of the US market by evaluating the risk-adjusted returns for investing internationally through either an ADR portfolio or a closed-end country fund. The commonly used measures are the Sharpe Index, the Treynor Index, and Jensens alpha.

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Sharpe Index (Sharpe 1966) compares the excess return of a portfolio to that portfolios total risk. The excess return is then calThe
as the average of the actual return minus the risk-free rate of The standard deviation of the portfolio is used as the basis for risk. The Sharpe Index is calculated as

culated
return.

where r - rf

is the average monthly return of the portfolio or country fund compared to the monthly risk-free rate of return. For a US investor, the relevant risk-free asset, rj, would be the three-month Treasury bill. The Treynor Index (Treynor 1965) similarly incorporates the excess return, but uses the beta of the security (portfolio) as the risk measure. The Treynor Index is calculated as

Jensens alpha (Jensen 1968) finds the excess return based on the Capital Asset Pricing Model. Given the systematic risk of the portfolio, the measure of the ability of the portfolio manager to outperform the market is found. Jensens alpha is calculated as

where r - 7r is the average monthly the relevant market for US investors.

4. Results

excess return

of the S&P

500,

performances of an individual investor constructing a portfolio compared to investing in a professionally managed portfolio are seen in Tables 3 and 4. Of the 23 country portfolios, 14 ADR portfolios were clearly superior to an investment in 21 of the country funds. For Germany, a self-invested portfolio of ADRs was superior to the Germany Fund, but not the New Germany Fund.
The relative
country

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40 /
Table 3

Monthly Returns and Standard Deviations for a

Countrys Portfolio of ADRs over the Period
1990-99

Notes: A

portfolio of each countrys ADRs was formed; weighted by the number of months each security was traded. The portfolios monthly returns and standard deviation were calculated for comparison to the monthly returns and standard deviation of the underlying Closed-end Country Fund(s).

Likewise, the Southern African Fund outperformed the ADR portfolio,

which had better results than ASA Limited did. For seven countries, the ADR portfolio had negative returns. This was also true of four of the country funds representing these countries. Overall, only seven country funds clearly outperformed the countrys
ADR

portfolio.

The primary success of the holding of an ADR portfolio was the lower resultant risk compared to the risk from holding a country fund. The standard deviations of 11 portfolios were lower than that of 14 of the corresponding country funds. For Brazil, France, Israel,

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Table 4

Monthly Returns and Standard Deviations for

Closed-end

Country Funds over the Period

1990-99

Notes: The country funds

monthly

returns

for

comparison

portfolios

the monthly for each country.

to

returns

and standard deviation were calculated and standard deviation of the ADR

Philippines, South Korea and Taiwan, the returns of the portfolios more than compensated for the somewhat higher risk. In only China,

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Indonesia, Mexico, Russia and Singapore would the country fund have
had lower risk without lower returns. These were all countries where the ADR portfolio had negative returns. In Austria and Chile, countries in which both constructed portfolios met with negative returns, the standard deviation of each was lower than the respective country funds.
4.1 I

Risk-adjusted

returns of the ADR

portfolios

Table 5 presents the risk-adjusted excess returns of the ADR portfolios based on the Sharpe, Treynor, and Jensen models. The portfolios are compared to the S&P 500, the benchmark for US investors. With all
Table 5

Comparison of ADR Portfolios Relatives to the US Market

over

the Period 1990-99

Notes:

*Statistically significant at the 5 per cent level. The systematic risk of each constructed portfolio is shown by the beta. The correlation of the portfolio to the S&P 500 is the square root of R. The Sharpe Index, the Treynor Index, and Jensens alpha are used to compare risk-adjusted performance.

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the ADR portfolios, the beta was significantly different from zero. Thirteen of the 23 portfolios had betas greater than that of the US market. Not surprisingly, the countries with the highest betas (Russia, Singapore, Indonesia and Mexico) had some of the most turbulent financial markets during the decade. Those with low risk tended to be developed countries with more diversified economies. The correlations between the US market and the separate portfolios are somewhat low, with the highest being that of Ireland (68 per cent). From this, the diversification benefits of international investments established by Levy and Sarnat (1970) are still evident. 500 is 0.3012. Twelve country The Sharpe Index for the S&P exhibit positive risk-adjusted returns. Only the investment portfolio in Spanish ADRs showed a better performance than that of the US market for the decade. The Treynor Index for the S&P 500 is 0.0115. Again, 12 country portfolios exhibit positive risk-adjusted returns. However, using the systematic risk as a measure, Taiwan, Germany, Switzerland and Spain had better performance than that of the US market. These same four countries exhibit positive alphas; however, none are significant. Five countries have significant alphas (China, Indonesia, Mexico, Philippines and Singapore); albeit, the alphas are negative.
4.2

Risk-adjusted

returns of the

country funds

Table 6 presents the risk-adjusted excess returns of the closed-end country funds based on the Sharpe, Treynor, and Jensen models. The country funds are compared to the S&P 500, the benchmark for US investors. With the exception of the New Germany Fund and ASA Limited, all the country funds have a beta that is significantly different from zero. Twenty-eight of the 33 funds have betas greater than that of the US market. The correlations between the US market and the separate funds are also low, with the highest being that of the Templeton Russia Fund (62 per cent). Again, the evidence indicates investment in international securities provides diversification benefits. Examining the Sharpe Index for the country funds finds that only 14 of the 33 funds have positive risk-adjusted returns. Only the New Germany Fund showed a better performance than that of the US market. A strong reason for this is the low beta of the fund relative to the 500 benchmark for the period. S&P

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44/ Table 6

Comparison of Closed-end Country Funds Relative to the

US Market
over

the Period 1990-99

Notes:

*Statistically significant at the 5 per cent level. The systematic risk of each Fund is shown by the beta. The correlation of the Fund to the S&P 500 is the square root of R2. The Sharpe Index, the Treynor Index, and Jensens alpha are used to compare risk-adjusted performance.

The results for the Treynor Index find that the same 14 country funds exhibit positive risk-adjusted returns. Again, only the New Germany Fund has better performance than that of the US market. The alpha of the New Germany Fund is significantly positive, which can

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be
to

again attributed to the low systematic risk of the Fund compared the S&P 500, whereas all other countries with significant alphas have negative results.
5. Conclusions
_

In contrast to the limited alternatives available in the past, US investors

gain access to international markets and investments through an increasing number of investment opportunities. Based on the results
can

shown in this article, there

are

still benefits to be derived from diver-

sifying internationally.
was

Prior to the past decade, the only access to many emerging markets through professionally managed investments funds. As countries ease the restrictions on allowing access to their financial markets, the international investor has greater access to individual securities that may provide better performance for the risk undertaken. The results of this article indicate that the individual investor, using an unsophisticated buy-and-hold strategy, can earn similar returns as those of fund
managers.

There are still many countries that do not have actively-traded foreign shares on the US markets. Many of these countries are accessed through country fund trading. However, the evidence shown here would provide some support for corporations from those countries to list shares or for banks to provide for more sponsored depository receipts.
Thomas S. Coe is at the Department of Finance, Quinnipiac University, 275 Mount Carmel Avenue, Hamden. E-mail: thomas.coe@quinnipiac.edu

REFERENCES

Aiello, S. and N. Chieffe (1999), International Index Funds and the Investment Portfolio, Financial Services Review, 8(1): 27-35. Bailey, W. and J. Lim (1992), Evaluating the Diversification Benefits of the New Country Funds, Journal of Portfolio Management, 18(3): 74-80. Bailey, W., K. Chan and Y. Chung (2000), Depository Receipts, Country Funds, and the Peso Crash: The Intraday Evidence, Journal of Finance, 55(6): 2693-717. Bonser-Neal, C., G. Brauer, R. Neal and S. Wheatley (1990), International Investment Restrictions and Closed-end Country Fund Prices, Journal of Finance, 45(2):
523-47.

Brealey, R. (1999), The Asian Crisis: Lessons for Crisis Management and Prevention, Journal of Applied Corporation Finance, 12(3): 111-23.

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Chen, G., M. Firth and O. Meng Rui (2002), Stock Market Linkages: Evidence from Latin America, Journal of Banking & Finance, 26(6): 1113-41. Coe, T. (1999), Do Closed-end Country Funds Mirror their Home Markets?, Journal of Emerging Markets, 4(2): 23-42.
Far Eastern Economic Review (1997-99), various issues. Gruber, M. (1996), Another Puzzle: The Growth in Actively Managed Mutual Funds, Journal of Finance, 51 (3): 783-810. Journal Jensen, M. (1968), The Performance of Mutual Funds in the Period 1945-1964, of Finance, 23(2): 389-416. Johnson, G., T. Schneeweis and W. Dinning (1993), Closed-end Country Funds: Exchange Rate and Investment Risk, Financial Analysts Journal, 49(6): 74-82. Levy, H. and M. Sarnat (1970), International Diversification of Investment Portfolios, American Economic Review, 60(4): 668-75. Mauro, P., N. Sussman and Y. Yafeh (2002), Emerging Market Spreads: Then versus Now, Quarterly Journal of Economics, 117(2): 695-733. Officer, D. and J. Hoffmeister (1987), ADRs: A Substitute for the Real Thing?, Journal

of Portfolio Management, 13(2): 61-65. Sharpe, W. (1966), Mutual Fund Performance, Journal of Business, 39(1): 119-38. Strong, R. (2001), Practical Investment Management (2nd ed.). Cincinnati: SouthWestern.

Treynor, J. (1965), How to Rate Management of Investment Funds, Harvard Review, 43(1): 63-75.

Business

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