Portfolio Design: A Modern Approach to Asset Allocation

ARE THERE SHORTCUTS TO OWNING FOREIGN STOCKS?

Investors have considered two shortcuts to owning foreign stocks that allow them to keep their money at home. The first shortcut involves investing in American Depository Receipts (or ADRs) instead of stocks of the same companies listed on foreign stock exchanges (foreign stocks). The second shortcut involves investing in the stocks of U.S. multinational firms that have extensive sales or production in foreign countries. The first shortcut represents a legitimate and convenient way to invest in foreign companies. The second shortcut fails to provide the foreign diversification that investors are seeking.

Consider first the ADR market. First developed in the 1920s, ADRs are negotiable certificates issued by a U.S. bank with rights to the underlying shares of stock held in trust at a custodian bank. These ADRs are sold, registered, and transferred within the United States like any share of stock in a U.S. company. Dividends are paid in foreign currency to the custodian bank that converts them to dollars. American investors find investing in ADRs very convenient compared with investing in shares in foreign stock markets. Investors do not have to worry about foreign currency transactions and custody remains in the United States.

FIGURE 5.10 Toyota Tokyo Stock Price in Dollars and Toyota New York ADR Price in Dollars.

Data Source: Datastream.

To what extent is the American investor getting true foreign diversification by investing in ...