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ADR’s or Foreign Funds? Which Are Best?

By: Investor Solutions

By: Investor Solutions, Inc.

The benefits of international investing cannot be denied. There have been countless articles and papers written on the subject already that are beyond the scope of this article. But what exactly is the best method of gaining international exposure in your portfolio? Should you consider exposure to foreign companies via American Depository Receipts or are mutual funds a more optimal solution?

American depository receipts (or ADR’s) are securities created by a U.S. bank that represent shares in foreign companies that are held at the bank. An ADR may represent a portion of a foreign share, one share or a bundle of shares. ADR’s themselves are not stocks, but certificates held by U.S. banks. Like U.S. common stock, ADR’s trade on U.S. stock exchanges and pay dividends (subject to U.S. taxation).

ADR’s, like most foreign mutual funds, are denominated in dollars, but they do not eliminate the potential currency risk associated with investing in foreign markets. So, when the dollar is weak, investment returns in foreign positions are usually more robust. Inversely, when the dollar rallies against foreign currencies, ADR’s from those countries will fall more than if shares were held by direct investors in the company.

Unfortunately, if your objective is to achieve global diversification in your portfolio, ADR’s are quite limiting. When you buy an ADR, you are gaining representation in one foreign company, a concentrated risk by most prudent standards. Furthermore, most ADR’s are limited to mid to large capitalization companies. So, even if an investor owned every traded ADR on the exchange, he/she would end up owning something similar to an EAFE index, but at a much higher acquisition cost.

We can all agree that the purpose of including foreign stocks in a portfolio is to control risk and maximize return. However, these dual objectives cannot be obtained solely with international large cap exposure (which is all that the ADR would provide). In order to accomplish your goal you should also include foreign value, foreign small, foreign small value and emerging markets. These simply cannot be attained with ADR’s.

So, for access to foreign markets, international mutual funds are a better alternative. They have the ability to provide broad global representation while spreading risk across hundreds of companies, sectors, and countries around the world. The aforementioned asset classes like foreign small, foreign small value et al are all available to investors.

It should be noted that because international stocks are more costly to trade, foreign funds typically carry higher expense ratios than their domestic counterparts. Furthermore, the dividends of international stocks are subject to foreign taxation-even when the recipients are tax-exempt in the US (like a pension plan). Taxable investors, however, can receive credits for foreign taxes paid. Of course, cost conscious investors should consider global index funds or exchange traded funds to keep costs to a minimum.

Yet despite the potential cost and foreign tax implications, international mutual funds (unlike ADR’s) allow investors to capture a broad array foreign exposure. When soundly combined with other domestic asset classes, international exposure is an essential building block in any optimal portfolio, and mutual funds (not ADR’s) provide you with the best tools to achieve that goal.