Do ADRs Offer a Solution for Fund Gaming?

Some foreign funds have found a good way to dodge the market-timing wars: American Depository Receipts.

Mutual funds that invest in foreign companies have long used ADRs as a way to gain foreign exposure without having to buy stock in foreign markets. But because ADR prices reflect news that could change prices in foreign stocks long after markets abroad close, funds may start using them more frequently to keep stale-price fund-timers at bay.

Michael Finck, managing director of the ADR division at Bank of New York(BK Quote), says activity has increased in ADRs in recent months, although it's too early to tell if funds are shifting their strategies in light of the timing scandals. Regardless, until pricing problems are solved at funds, investors may want to consider foreign funds that use ADRs.

As we've all heard lately, the price at which investors buy and sell mutual funds doesn't always accurately reflect the true value of the portfolios' investments. This flaw is the foundation of the fund-trading scandal. Rules designed to protect this flaw were bent to allow certain parties to profit from the pricing irregularities -- to the direct cost of other fund investors.

While plenty of fixes exist to lessen the problem -- redemption fees punish shorter-term investors, earlier cut-off times for fund trading seek to minimize stale pricing, limitations on total trades per year keep frequent traders at bay -- ultimately the gap between a fund's price and a fund's true value needs to be reduced to protect longer-term investors.

Depositary Receipts are tradable U.S. securities representing a non-U.S. company's stock. The common form for U.S. investors is an ADR. ADRs trade just like a U.S. stock during regular market hours and offer one way for fund managers to minimize the gap between real fund value and quoted fund prices.

Nowhere is this gap between real value and quoted fund prices more apparent than with funds that invest in foreign stocks. While you can buy a fund that invests in Japanese stocks until 4 p.m. New York time, the actual underlying stocks in the fund's portfolio may have stopped trading up to 15 hours earlier. Fifteen hours of world news -- including price action in the U.S. market -- could mean the true value of a stock is very different than the last official closing price in Tokyo.