THE APERIO DIFFERENCE. Authors Michael Branch, CFA Ran Leshem CONSIDERATIONS WHEN CONSTRUCTING A FOREIGN PORTFOLIO: AN ANALYSIS OF ADRs VS ORDINARIES U.S. investors can capture international equity exposure by investing directly in overseas markets or by purchasing shares of American Depositary Receipts (ADRs). The choice of which instrument to use has important implications for transaction costs, ongoing fees and benchmark tracking. In this paper, we evaluate the relative merits of ADRs vs. ordinaries, and present a framework to quantify and minimize implementation costs in foreign portfolios. APERIO GROUP, LLC Copyright 2011 Aperio Group, LLC Three Harbor Drive, Suite 315, Sausalito, CA 94965 Phone: 415.339.4300 Fax: 415.339.4301 www.aperiogroup.com
ADRs AND ORDINARIES: OVERVIEW An American Depositary Receipt (ADR) is a certificate issued by a U.S. depositary bank 1 representing ownership of a publicly traded foreign corporation. Each ADR represents a specific number of underlying ordinary shares on deposit with a custodian in the applicable local market. ADRs pay dividends in U.S. dollars and are listed on U.S. stock exchanges or traded on the OTC market. Since ADRs are fundamentally equivalent to foreign ordinary shares, they share the same economic, political and currency risk exposure as the underlying security. The primary benefit of ADRs is convenient access to international markets without the challenges of cross-border and cross-currency transactions. ADRs are traded just like U.S. stocks so investors enjoy low trading commissions, deep liquidity, English language reporting, proxy voting rights and favorable tax treatment. 2 The rapid expansion in ADR issuance over the past decade has resulted in significant improvements in foreign market coverage. As the following table illustrates, the preponderance of world market capitalization is now accessible through ADRs: Aperio ADR Universe Vanguard World ex U.S. ETF Market Securities Market Cap. Securities Market Cap. Developed 325 $9.0 Trillion 623 $12.4 Trillion Emerging 197 $2.6 Trillion 173 $3.2 Trillion The Aperio universe includes all liquid, investable ADRs trading on U.S. exchanges. The Vanguard ETF (VEU) holds foreign ordinaries benchmarked to the FTSE All-World ex U.S. Index Sources: Aperio Group and Vanguard, May 31, 2010 For larger portfolios, foreign ordinaries provide superior liquidity, comprehensive universe coverage and improved benchmark tracking. Ordinaries typically have higher trading commissions and may entail additional trading or operational complexity. For example, many custodians require separate accounts to manage currency exchange. In the next sections we evaluate the key differences between ADR and ordinary portfolios: tracking error and transaction costs. 1. Depositary bank services are dominated by four major commercial banks: The Bank of New York Mellon, JPMorgan, Citibank, and Deutsche Bank. 2. ADRs are exempt from stamp duty a tax levied on security sales in certain foreign markets (e.g. London, Hong Kong). 2
ADRs vs. ORDINARIES: TRACKING BENCHMARKS Tracking error is an important attribute of any index portfolio. Tracking error measures how closely a portfolio follows the index to which it is benchmarked. A portfolio with identical security weights as the benchmark will have a tracking error of 0%. Most indexed portfolios in separately managed accounts and ETFs do not fully replicate the benchmark and have some residual tracking error. In this section we analyze the tracking issues for portfolios using ADRs versus ordinaries. Aperio uses risk models and optimization software to replicate the top international indexes with minimal forecasted tracking differences. The following table compares the expected tracking error of Aperio s ADR and ordinary portfolios: Tracking Error Benchmark* ADRs Ordinaries MSCI World 0.53% 0.37% MSCI All Country World 0.58% 0.40% MSCI EAFE 0.95% 0.60% MSCI World ex U.S. 0.80% 0.40% MSCI AC World ex U.S. 0.84% 0.50% *See Appendix for detailed benchmark definitions Both ADR and ordinary portfolios have low tracking error (< 1%) across benchmarks. Ordinary portfolios achieve tighter tracking than ADR portfolios due to a larger universe of liquid securities. Apart from asset selection tracking error, ADR portfolios experience additional tracking differences due to a unique performance measurement issue. Since ADRs trade on U.S. exchanges, their returns are computed based on closing prices in U.S. markets. Foreign index returns, however, are calculated using closing prices from each respective local market. Since the U.S. exchanges close each day long after foreign markets, pricing differences can arise between a specific U.S. listed ADR and its foreign listed counterpart. For example, market participants in New York will bid up the price of Japanese ADRs based on favorable news released after the market close in Tokyo (1:00 a.m. in New York). These return differences caused by non-overlapping market trading hours are random and immaterial over longer measurement periods. 3
ADRs vs. ORDINARIES: TRANSACTION COSTS When deciding between ADRs and ordinaries, investors should consider trading costs in addition to tracking error. The relative cost advantages are not always apparent and need to be carefully modeled for each investor based on their unique circumstances (portfolio size, trading activity, custodian bank, etc.). The table below compares ADRs and ordinaries across the major expense categories: ADRs Note: Bold formatting indicates the lower cost alternative Ordinaries Trading Commissions Cheaper More Expensive Bid Ask Spreads* Higher (0.20%) Lower ( 0.14%) Exchange Fees / Stamp Taxes Foreign Exchange Bid-Ask** Annual ADR Fees (Charged by ADR depositary bank) No None $0.01-$0.03 per share (0.07% portfolio) Yes (London 0.25% & Hong Kong 0.19%) Varies. Mainly on Initial Trade (0.05%) Ordinaries are generally more expensive to trade and custody. Some exchanges impose stamp taxes on trades which could be substantial. On the other hand, ADRs incur depositary pass-through fees that amount to about 7 basis points per year. This annual pass-through fee will often give ordinaries the cost edge in lower turnover strategies where custody fees outweigh trading costs. Ordinaries typically have lower bid-ask spreads than ADRs (0.14% vs. 0.20% for EAFE securities). This lower bid-ask spread is a result of higher liquidity in local markets. For index portfolios of less than $50 million, trades significantly impacting the spread are uncommon due to the relatively small value of individual positions. Large institutional portfolios with concentrated holdings may have a much larger market impact, and ordinary trading becomes a necessity for cost control. In the next section, we demonstrate Aperio s cost analysis model for measuring portfolio implementation costs using a real-world example. No Annual Custody Fees Varies Varies * Bid-ask spreads were measured by Aperio Group over a representative sampling period in June 2010. EAFE securities were used for the study. ** Bid-ask spreads on currencies vary by broker. Average spreads ~ 5 basis points. 4
ADRs OR ORDINARIES: COST MODEL EXAMPLE Given a client s total assets, forecasted turnover, and custodial/brokerage fees, the Aperio Portfolio Cost Analyzer (APCA) calculates the annualized cost to implement an all-adr, allordinary, or blended portfolio. The blended portfolio uses ADRs for London and Hong Kong securities (where stamp taxes are high), and ordinaries for the remaining exchanges. In this example, we modeled implementation and ongoing costs for a hypothetical investor with $60 million invested in an MSCI EAFE tax loss harvesting portfolio. The following table outlines the key assumptions: ADRs Ordinaries Trading Commissions 0.03% of trade 0.04% of trade Bid Ask Spreads 0.20% 0.14% Exchange Fees/Stamp Taxes - London 0.25%, Hong Kong 0.19% Custodian Costs - $10 per trade Foreign Exchange Bid-Ask - 0.05% on initial trade Annual ADR Fees 0.07% - Annual Custody Fees None None As the table below summarizes, the ordinary portfolio has an annualized drag of 7.5 basis points for custody and trading expenses. The ADR portfolio costs 13 basis points annually. These cost differences stem from the absence of ADR fees when using foreign ordinaries. The tax-efficient blended portfolio is the least costly at 7.1 basis points per annum. Portfolio ADR Only Ordinary Only Blend Annualized Cost 13.0 bps 7.5 bps 7.1 bps The cost model reveals that ordinaries, although more expensive to trade, are generally cheaper than ADRs when considering all applicable fees and expenses. However, a smart combination of both ADRs and ordinaries can often be the best and least expensive portfolio. Incorporating cost estimates, tolerance for tracking error and operational constraints, investors can now make an informed decision when constructing foreign portfolios. 5
CONCLUSIONS Investors trade off transactions costs, tracking risk and operational complexity when deciding whether to use ADRs or ordinaries. ADRs can be used effectively to track broad market foreign indices. Aperio uses risk modeling and optimization to minimize tracking differences. The transaction cost differences between ADRs and ordinaries are small for index portfolios, even when factoring in bid-ask spread differences. An ADR/ordinary blend is usually the most cost effective solution for foreign portfolios. It allows investors to avoid expensive stamp taxes while receiving the benefits of ordinary investing. Disclosures: The information contained within this presentation was carefully compiled from sources Aperio believes to be reliable, but we cannot guarantee accuracy. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. In particular, none of the examples should be considered advice tailored to the needs of any specific investor. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. With respect to the description of any investment strategies, simulations, or investment recommendations, we cannot provide any assurances that they will perform as expected and as described in our materials. It is important to understand that good past performance does not guarantee good results in the future. Future performance and risk may be different from the past. Every investment program has the potential for loss as well as gain. 6
Appendix: Benchmark Definitions MSCI All Country World Index (ACWI) MSCI World Index MSCI Emerging Markets Index MSCI Europe, Australasia, and Far East (EAFE) Index Americas United States Canada Austria Belgium Denmark Finland France Germany Greece Ireland Europe Italy Netherlands Norway Portugal Spain Switzerland Sweden U.K. Israel Pacific Australia Hong Kong Japan New Zealand Singapore Americas Brazil Chile Colombia Mexico Peru Europe, Middle East & Africa Czech Republic Egypt Hungary Morocco Poland Russia South Africa Turkey Asia China India Indonesia Korea Malaysia Philippines Taiwan Thailand Source: MSCI Inc. Aperio v. [Latin] to make clear, to reveal the truth