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
, 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.
Just because a market has closed doesn't mean stock values stop changing. As a stark example, if a tsunami hits Tokyo at 3 p.m. New York time, a U.S. investor could sell a Japan-focused mutual fund at 4 p.m. and avoid the likely fall in Japanese stock prices when the market opens in Japan a few hours later. The fund's closing price (in the absence of fair value pricing adjustments) uses stock prices from Tokyo before the tsunami struck -- prices that in all likelihood are artificially high given the news.
ADRs, meanwhile, trade in the U.S. market, so if a typhoon hit Japan at 3 p.m. New York time, you would expect the price of ADRs for
to start falling immediately to reflect the likely fall in the underlying share prices when the market opens up in Tokyo.
If a Japan fund owned only ADRs, the fund's price would likely drop by 4 p.m. and there would be no way to game the fund by capitalizing on a gap between real and quoted value. If another fund owned the exact same companies, but owned the stocks directly in the foreign markets, there would be an opportunity to exit the fund at 4 p.m. and avoid the drop in the fund's price, which would take place the next day after the prices in Tokyo change.
A typical international mutual fund owns a mix of foreign stocks and ADRs.
Bank of New York's Finck says he doesn't understand why funds don't use ADRs instead of owning foreign shares directly. Finck points to lower custody costs of owning ADRs (costs paid by fund shareholders) and arbitrage-driven price parity that in most cases makes the choice of buying the underlying stock or the ADR a nonissue.
Factor in the benefits of owning a security that is more accurately priced at the close of U.S. trading and Finck feels ADRs could be part of the solution in the mutual fund-timing scandal.
Bank of New York has just under 70% of the market for ADRs;
J.P. Morgan Chase
make up the rest of the market. Bank of New York has a vested interest in the growth of ADR trading -- it profits when ADR shares are created and cancelled and from the ongoing arbitrage process that keeps ADR prices in check. Bank of New York could be a curious beneficiary as fund companies have to readjust their foreign stock ownership strategies in light of the fund-gaming scandal.
ADRs don't exist for every foreign stock. Current programs account for about $4 trillion in foreign market cap -- less than half of total foreign market value. This means many foreign companies can only be purchased abroad.
Another trouble with ADRs is liquidity. Underlying stock in foreign markets can trade more frequently -- and with lower friction costs for bigger trades -- than ADRs. Less liquidity could mean other mispricing issues crop up. If an ADR doesn't trade for the last few hours of the day, pricing could be almost as stale as foreign markets' last closing price for a stock.
Today a fund manager looks at several factors when choosing an ADR over foreign shares.
According to James Moffett, portfolio manager of the UMB Scout Worldwide Select fund and the UMB Scout Worldwide fund, whether you are going to buy and hold or trade a stock matters. Custodial costs -- which are ongoing -- are lower for ADRs. These costs can be as high as 0.4% a year, far more than what funds pay for custody on U.S. shares and ADRs.
Trading costs could be lower for foreign shares if the foreign market is more liquid for the underlying stock than the ADR market in the U.S. If you are going to buy a stock for five years, the ADR could be cheaper; if you are going to buy and sell it three times in a year, the foreign shares could be less expensive as the friction costs from trading the ADR would exceed the savings in custody.
Additionally, the premium or discount of the ADR over the foreign shares comes into play, a data point readily available on
terminals. Such decisions by fund managers help keep the prices in the two markets in check.
Moffett doesn't trade frequently and his fund mostly holds ADRs. In total the fund is about 80% priced in the U.S. market, which makes it a poor target for fund-timers. Not that they haven't tried.
Some fund companies have foreign offices and are more inclined to trade during their time zone in their markets. Funds that only have U.S. offices may prefer to trade in U.S. markets.
Another factor is fund size. From an initial review, it seems like larger funds tend to own foreign shares. This may be because they have bigger liquidity issues trying to move billions into foreign stocks, and need the local market liquidity to pull off the trades. As discussed in an
earlier article, small funds already have advantages in the war against fund-timing because timers and their enablers can't hide trades in a small fund as readily. Being able to trade in less liquid ADRs may be another advantage of smaller foreign funds.
On Sept. 30 the Janus Overseas fund, which has $2.8 billion in assets, had two ADRs in the top 10 holdings. The Janus Worldwide, with $11.4 billion, had none. Worldwide is a global fund and also owns U.S. stocks. The $8 billion Artisan International fund had no ADRs in the top 10. The new, small and hot Artisan International Value fund had one. The Dodge & Cox International fund, with $200 million in assets, held about 50% of its assets in ADRs on June 30, 2003. This pattern may not mean larger funds have to avoid ADRs.
Time will tell if funds use more ADRs to help combat stale-pricing issues. Fund analysts and data aggregators also may need to change with the times. None of the well-known fund-screening products let you check on ADR ownership. Other than going through dated fund filings one by one, fund investors have no way to determine how much of a foreign fund's portfolio is priced in the U.S. market or abroad.
Jonas Max Ferris is co-founder of
MAXfunds.com, a fund research and analysis company, and partner in an investment advisor offering managed accounts in mutual funds. He welcomes column critiques, comments or baseless accusations at