American Depositary Receipts are an effective way for US investors to gain exposure to international stocks. Dorsey, Wright & Associates’ John Lewis (pictured) explains how using a momentum strategy can prove effective in building the right exposure to this instrument class.
Back in July 2014, the Sterling/US Dollar exchange rate was reached a high of USD1.71 but since then it has headed south, falling as low as USD1.29 following Brexit.
This downward trend has been a boon for US investors travelling to Europe on vacation. And whilst many have continued to focus their investment portfolios on US domestic stocks, the idea of actually owning international stocks has taken a back seat.
This is ill advised, however, given that there are already early signs that the US dollar might be softening; indeed, the sterling has just risen to USD1.327 on the back of strong manufacturing data.
Rather than overlook the vast array of opportunities that exist to hold securities in dynamic international companies, there is a viable solution: American Depositary Receipts (ADRs). These have long been used (since 1927) to allow US investors easy access to foreign companies without having to set up overseas brokerage accounts. Simply put, an ADR is a dollar-denominated certificate issued by a US depositary bank that represents a specific number of shares in a foreign company trading on a US stock exchange.
“You can buy a foreign company’s stocks in the US without having to deal with currency issues. Also, the depositary bank issuing the ADR will convert dividend payments into US dollars and take care of any foreign tax issues,” says John Lewis, Senior Portfolio Manager at Dorsey, Wright & Associates (DWA) a Nasdaq company that has been running a systematic momentum factor ADR strategy for the past decade.
ADRs represent an ideal opportunity today for US investors to gain access to international markets such as the UK, which has been enjoying a surprising market rebound since Brexit, the FTSE 100 having exceeded 6,800.
“There are a large number of developed and developing market companies that list ADRs across the capitalisation spectrum; small cap through to large cap. It’s a wide dispersion of companies that do ADR listings.
“Investors in the US, as well as those in Europe and Asia, have a home country bias when it comes to investing so getting international exposure, in general, is a good thing for investors to consider. Also, the US dollar has stopped heading northwards – when it was rising, of course the US stock markets were the only game in town for US investors as international markets underperformed on a relative basis.
“But the US dollar has started to slow slightly and international markets to perform better. I think as the US dollar flattens out, international investments are going to look much more attractive to US investors,” remarks Lewis.
To take full advantage of the opportunities on offer, DWA utilises a smart beta strategy by focusing exclusively on momentum and trend so as to provide investors with a viable route to holding foreign stocks without the operational headaches associated with buying stocks on international exchanges.
Indeed, the fact that ADRs are settled in US dollars is an ideal way to hedge against a slower US dollar growth, as investors get not only the capital gains of well-performing international stocks, they also benefit from the associated currency tailwind (i.e. a stronger sterling).
“Our models have been picking up allocations in Latin American ADRs this year. That market has proven to be very good for us and there are plenty of good Latin American ADRs, which we’ve been adding as new positions in areas such as basic materials,” says Lewis.
DWA’s investment model focuses on momentum signals to identify the best ADRs to hold in the strategy at any given time. The implication to this is that it holds the winners and drops the losers; something that behavioural biases implicit in human beings struggle to overcome.
“Our international ADR strategy has been one of our best performing strategies over the past 10 years. I think one of the reasons for that is that the ADR market is very dynamic. There are a lot of interesting companies across the globe providing a wide dispersion of returns, and that’s very beneficial to our type of model,” says Lewis, who continues:
“We don’t use any fundamental factors (valuations, earnings, analyst revisions); our model is based purely on market price movement. The model looks at a universe of 400 to 500 ADRs and ranks them based on momentum scores every day. It is a very systematic and disciplined process. We hold anywhere in the region of 30 to 40 ADRs in the strategy. We have a very strict sell discipline. Once an ADR falls below a pre-determined rank we sell it and buy the strongest momentum ADR that we don’t currently hold in the portfolio.”
That the model is market price data-driven is quite unique in the ADR space. It means that Lewis and his team can objectively look at large numbers of international companies and place them all on the same footing.
Given that there are tremendous variations in respect to currency fluctuations, political developments etc. that one has to be mindful of, when trading international ADRs, by focusing on market price the DWA model is able to analyse companies in different economic cycles.
“We look at the ADR universe every day. If there’s a major move in the global markets we will immediately sell ADRs that are losing momentum and replace them with something stronger. Turnover in the portfolio tends to be lumpy. When there are major changes in leadership – i.e. country leadership, sector leadership – there tends to be more trading activity. Since we are a trend following strategy, as long as that leadership is sustainable there may be long periods where we are not doing a lot of trading. Our strategy is quite unique in that way. We’re not doing a full rebalance every month or quarter.”
Such has been the success of its momentum approach that AdvisorShares, a leading sponsor of actively managed ETFs, announced on 30th August 2016 that it had selected Dorsey, Wright & Associates as sub-advisor to the AdvisorShares WCM/BNY Mellon Focused Growth ADR ETF (NYSE Arca: AADR).
“Dorsey, Wright and Associate’s well-established expertise and track record of industry-leading technical investing is evident, particularly in their international equity approach that will be employed in AADR,” said Noah Hamman, Chief Executive Officer of AdvisorShares.
DWA’s model has shown that the momentum factor can be highly successful when applied to the ADR market. Lewis cites a couple of reasons for why this is so:
“Firstly, it makes it very quick and objective for us to analyse a large set of companies that exist under different circumstances. It’s just as easy for us to look at a consumer staples company in the UK as it is a gold mining company in South Africa. Using that kind of objective measure for investors is very valuable.
“Secondly, as referred to previously, there is a wide dispersion of performance in global ADRs. A particular ADR may perform very well one year and less so the next. That dispersion profile is perfect for us because we can focus on areas of the globe doing well and totally exclude those that are underperforming.”
To conclude, Lewis says that rather than thinking about momentum in isolation, investors could consider using a strategy such as DWA’s in tandem with a value factor strategy.
“If you use a momentum strategy like ours, and find a manager that is very good on the valuation side, by combining those two strategies the excess returns are negatively correlated; in other words, they outperform at different parts of the cycle. Mixing those two factors together can be additive and that is what US investors have been increasingly doing over the last few years.”
With different parts of the global economy growing at different rates, gaining exposure to ADRs through a smart beta strategy such as DWA’s is proving to be an increasingly compelling consideration. If the dollar weakens, US investors will need solutions.
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