Understanding The ADR Markets

American
Depositary
Receipts
Understanding the ADR
Markets
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Cambiar Insights
2016
Growing U.S. investor appetite for international equity
exposure has increased demand for asset managers that
provide international ADR portfolios. With the growth in
assets and interest, many research groups are starting
to delve deeper into the dynamics of the ADR market. In
this paper, Cambiar aims to shed some light on the most
commonly asked questions, as well as to dispel some of the
misconceptions regarding ADRs.
What are the pros & cons of using
ADRs?
Pros: ADRs provide U.S. investors with an easier method of
investing in foreign companies as ADR shares are priced and
pay dividends in U.S. dollars. Additionally, ADR accounts do
not require the client to setup and maintain sub-custodian
trading accounts directly in the local markets, which saves
considerable time, effort, complexity and expense. The
primary advantage of using Unsponsored ADRs is the
increased size of the investment universe.
What are ADRs?
American Depositary Receipts (ADRs) have been in existence
since the 1920s and provide U.S. investors with an effective
way to buy, hold and sell foreign companies with reduced
transaction, settlement and custodial costs. ADRs are created
when a broker purchases securities of a foreign company
directly in the local market and then delivers the shares to
a depositary bank (i.e. BNY Mellon, Citibank, JP Morgan or
Deutsche Bank), which in turn issues ADRs that are traded on
U.S. Exchanges or in the OTC market. ADR securities trade
freely at prices historically close to that of their underlying
ordinary shares using the relevant foreign exchange rate.
Cons: While the growth in the ADR market has greatly
increased the number of available ADRs (more than 2,700 in
total), this remains smaller than the foreign equity universe of
about 6,200 securities. As discussed earlier, the same level of
compliance and reporting is not required for all types of ADRs.
ADR holders may not have access to rights offerings as they
may only participate in those offerings the companies register
with the SEC. Companies with Unsponsored or Level 1 ADRs
may or may not grant voting rights to their ADR holders.
Lastly, while it is not always the case, Unsponsored ADRs are
generally less liquid than Sponsored ADRs.
There are two basic types of ADR securities: Sponsored and
Unsponsored. A Sponsored ADR program is established by
one depositary bank that has a direct agreement with the
foreign company whose shares the ADRs represent. An
Unsponsored ADR is typically established in response to
market demand by depositary banks that do not necessarily
have an agreement in place with the underlying company.
Additionally, Sponsored ADRs are available in three levels
(1, 2, and 3). Companies with Level 2 and 3 Sponsored
ADRs must register with the SEC and thereafter report their
financial statements in accordance with U.S. GAAP. To be
eligible to have Unsponsored or Level 1 ADRs, companies
must have current financial statements and annual reports
posted on their websites and issue material information
via electronic press release in English. Many foreign
companies have delisted their Level 2 or 3 ADRs as the cost
of compliance and reporting became cumbersome. Level 2
and 3 ADRs trade on U.S. exchanges, whereas Unsponsored
and Level 1 ADRs trade in the OTC market. Many investors
believe that Unsponsored and Level 1 ADRs are only for small
foreign companies; however, this is not the case (e.g., Nestle,
Roche, Heineken, Gazprom, BMW).
How closely does an ADR and its
corresponding local share track on a
performance basis?
Generally speaking, ADRs and the underlying local market
security track very closely at both the Price Return and Total
Return level. Cambiar recently conducted a performance
tracking analysis for our current ADR holdings and found that
over the last one and three-year periods (using daily returns)
our ADR holdings have tracked tightly on average with the
underlying local market security. The average total return
differential on a cumulative basis was between +/- 50 bps
across these time periods. We consider this to be well within
acceptable limits, and this indicates that clients are not being
disadvantaged by investing in ADRs versus the local market.
While emerging market ADRs and the more thinly traded
ADRs do have slightly increased variance in performance, the
averages are still in our comfort zone and this is something
that our traders work to minimize as best possible.
Describe the size of the ADR market
Dividends for ADR securities are based on the underlying local
market security’s dividend distribution and the conversion
ratio for local to ADR shares. Many countries withhold taxes
on dividends paid and while the American investor must still
pay U.S. income tax on the net dividend, the amount of the
foreign tax may be claimed by the investor as a deduction
As of 8/31/15, there were approximately 2,779 ADRs (1,211
Sponsored / 1,568 Unsponsored). (source: BNY Mellon)
against income. Short term, long term and dividend income
tax rates for ADRs are the same as that of U.S. common
equity investments.
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American Depositary Receipts
2016
billion DRs, and DR trading value increased by 29% over
2013 with $3.3 trillion in DRs changing hands. The value of
DR ownership increased by more than $53 billion (up 7%) for
a total of $876 billion.”
Has the ADR market been growing?
The ADR universe continues to grow. An additional 529
ADRs were established from the beginning of 2010 to yearend 2014. While the number of Sponsored U.S. Exchange
Listed ADRs over this time decreased by 12, the number of
Sponsored Over-the-Counter (“OTC”) ADRs increased by
57 and the total number of Unsponsored OTC ADRs by 484
programs.
How large is your investable ADR
universe?
When determining how to trade an ADR security we first
review the U.S. market liquidity (both Exchanges & OTC)
and if it is not sufficient to complete our order we defer to
the local market liquidity. Thus, the underlying local market
liquidity is ultimately the determining factor when analyzing
our investable universe, as we are able to work with our
brokers and the depositary banks to purchase local market
securities and create ADRs when necessary. However, we
do require the ADR to at least have a daily price, so that
our clients are able to consistently strike an NAV for their
accounts. Given our portfolio construction and trading /
liquidity parameters (provided on the next page), we estimate
our investable universe to be over 1,200 ADR securities.
The dramatic increase in the number of Unsponsored ADRs
is a direct result of an SEC rule change to Rule 12g3-2 (b)
on October 10th, 2008. The key change granted foreign
companies that are in compliance with Rule 12g an automatic
exemption, whereas previously the company had to actively
apply for the exemption. This in effect allowed depositary
banks (BNY Mellon, Citibank, JPM, Deutsche Bank) to launch
ADRs based on market demand with or without consent
of the foreign company and resulted in around 700 new
Unsponsored ADRs being launched within six months of the
rule change.
Total Sponsored and Unsponsored
Depositary Receipt Programs
Are there any countries or sectors
where there is limited ADR coverage?
4,000
3,000
1,229
1,391
1,532
689
695
676
654
603
794
829
845
841
851
376
397
403
396
392
385
296
337
362
370
343
303
2009
2010
2011
2012
2013
2014
1,060
2,000
690
1,000
0
748
LSE/LuxSE
1,116
U.S. Listed
U.S. OTC
Other/Unlisted
1,600
Cambiar has had difficulty in the past finding adequate
coverage in Taiwan, South Korea and India, as well as many
frontier market countries; however, this is not an active
universe for Cambiar given the strategy’s bias towards
developed markets. We have not had material issues finding
adequate coverage in any particular industry or sector since
the inception of the International ADR strategy.
What are your trading & liquidity
requirements when investing in
ADRs?
Unsponsored
Generally speaking, when purchasing ADR securities we
typically want to keep our trades to less than 1/3 of the
average daily volume. Cambiar’s traders carefully assess the
liquidity that is available via the ADR versus the local market
security and when additional liquidity is needed we will work
with our brokers to effect the trade in the local market and
create an ADR share.
What are the most notable trends in
the ADR market?
Over the trailing three and five year periods the substantial
growth in the Unsponsored ADR market (as discussed earlier)
is the largest trend and it has had a meaningful impact on
International ADR managers ability to replicate their local
market ordinary share strategies.
What is the process of converting
ordinary shares into OTC-traded ADR
Securities?
According to BNY Mellon Depositary Receipt Market 2014
Yearbook:
The conversion of ordinary shares into ADRs typically
happens when the ADR has limited liquidity in the U.S. OTC
“The DR market strengthened in 2014. Issuers raised over
$38 billion—three times more than in 2013, and a post-crisis
record… Robust demand prompted the creation of 166 DR
programs for issuers from 37 countries… Secondary market
activity was also vigorous. Trading volume grew 8% to 159
market and the investor needs to access greater trading
volume directly in the local market to execute the order. For
example, (as of 11.30.15): ADS GR (Adidas AG) averages
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American Depositary Receipts
2016
1.1 million shares in daily trading volume in the local market;
whereas, the unsponsored ADR (ADDYY) trades U.S. OTC
and averages 150,000 shares in daily volume. The ADR
volume is sufficient for smaller trades, such as trims/adds and
individual client contributions/redemptions, but in the case of
an outright new buy or liquidation, Cambiar would most likely
seek to access the deeper pool of liquidity directly in the local
market to have ordinary shares converted into ADRs.
What percentage of your ADR trades
are in U.S. markets versus in local
markets?
Assuming a $4-$10 billion asset base for the International
ADR strategy and utilizing our 2015 trading data and
parameters, we would be conducting approximately 40% of
our trades in U.S. markets, and 60% solely in local markets.
This would be the case for full position buys and sells,
whereas trims and adds could largely be conducted in the
U.S. markets or a combination of U.S. and local.
Process example: (ADS GR / ADDYY): Cambiar would send
an order to buy or sell one share of ADS GR per 2 ADRs
needed (Conversion ratio is 2 ADRs per ordinary share) to
an execution broker. After the total execution of the order
has been completed, Cambiar would cross reference the
current FX rate of the Euro (i.e. local market currency) versus
the executed quantity and book the ADR quantity and USD
converted price. Cambiar’s desk would additionally cross
reference the price prints of the ADR (ticker: ADDYY) in the
U.S. OTC market to confirm efficient and accurate execution
of the trade. The calculation behind this type of trade is as
follows: (ADS GR price = €91.26) x (1.06 Euro to USD rate)
x (0.5 Conversion Ratio) = ( $48.37 USD ADDYY) – ($0.045
Credit for unsponsored ADR Creation) = $48.323 USD ADDYY
executed price. All normal settlement procedures apply to
the resulting ADRs (both Sponsored and Unsponsored).
The roundtrip of trading an unsponsored ADR is typically
$0.005 per ADR. In practice, the executing broker and the
underlying depositary bank credit an investor $0.045 per ADR
(as detailed above) at the time of purchase when converting
the ordinary share to an ADR. When the ADRs are canceled,
$0.05 per ADR are debited back to the broker and bank—for a
net cost of $0.005 per ADR.
Normal commission rates apply whether you are purchasing
an ADR directly in the U.S. market or having ordinary shares
converted into ADRs, and typically run about $0.03-$0.05 per
ADR.
Do you invest in Unsponsored ADRs?
Yes, Cambiar invests in Unsponsored ADRs and began doing
so in 2006 when we launched our International ADR strategy.
In order to get comfortable with the trading and operations
of Unsponsored ADRs Cambiar approached multiple trading
desks to further our understanding of the structure, liquidity,
settlement, etc. of these types of securities. As we began
investing in Unsponsored ADRs, we closely monitored the
execution of the trades to ensure the pricing and liquidity was
consistent with our expectations. For Unsponsored ADRs that
required us to create the ADR, we were particularly mindful
of intra-day FX rates and the conversion prices. Cambiar
The information included is for informational purposes only
and is not a solicitation or offer to participate in any particular
investment product. The specific security identified and
described does not represent all of the securities purchased,
sold or recommended by Cambiar, and the reader should
not assume that investments in the security identified and
discussed were or will be profitable.
continues to monitor these critical trading factors when
executing trades today.
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American Depositary Receipts
2016