Performance Evaluation of American Depositary Receipts on Stocks from Africa and the Middle East
Arugaslan, Onur, Samant, Ajay, Journal of Global Business and Technology
This study bridges the gap between investment theory and practice in some of the least studied financial markets of the world, namely the stock markets in Africa and the Middle East. The objective of this pioneering study is to provide empirical documentation to global investors who are contemplating participation in African and Middle Eastern stock markets using American Depositary Receipts (ADRs) as the investment vehicle. The first part of the study examines the nature of these ADRs (based on depositary bank, sponsorship status, industry classification, and listing). The second part of the study evaluates the performance of these ADRs using statistical measures grounded in modern portfolio theory. Returns are adjusted for the degree of total risk and systematic risk inherent in each ADR, and the securities are then ranked on the basis of risk-adjusted performance. Two relatively new evaluation metrics, the Modigliani and Sortino measures, are used for ranking.
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Over the past decade, there has been a significant rise in investor comfort with global financial securities, aided by the ease and convenience with which transnational corporate information can be accessed via the internet. One of the most convenient vehicles for accessing corporate securities listed outside the investor's home country is a Global Depositary Receipt. In the United States, these securities are known as American Depositary Receipts (ADRs). As of January 2012, there were 2,442 ADRs listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), the NASDAQ system, and on private trading networks.
Although ADRs in general have been studied extensively, to our knowledge there has been no study of the nature and performance of ADRs on shares of firms incorporated in Africa and the Middle East. The stock market in this region is significant in size and provides many opportunities for risk diversification. Table 1 reports market capitalization and volume of trade for several markets in the Middle East and Africa in 2009 and 2010. Total market capitalization in the Middle East and North Africa in 2010 was US Dollar (USD) 1,257 billion. Of this amount, the Arab world accounted for USD 950 billion. The corresponding figures for value of stock traded are USD 506 billion and 356 billion, respectively. In 2009, the market capitalization and value of stock traded in developing countries in the Middle East and North Africa were USD 272 and 116 billion, respectively. Data for developing countries only, for 2010, was not available. In sub-Saharan Africa, market capitalization and value of stock traded in 2010 was USD 1 12 billion and 35 billion, respectively.
The largest market in this region, in terms of market capitalization (USD 1,013 billion) as well as volume of trade (USD 340 billion) in 2010 was South Africa. In the Middle East, the largest markets in terms of market capitalization in 2010 were Saudi Arabia (USD 353 billion), Turkey (USD 307 billion), and Israel (USD 218 billion). On the continent of Africa, the largest markets are Egypt (USD 83 billion), Morocco (USD 69 billion) and Nigeria (USD 51 billion).
Many US based investors find it inconvenient, for a variety of reasons, to invest directly in stock markets in Africa and the Middle East, and, therefore, prefer to invest in ADRs based on their stocks. These ADRs may be created at the request of investors or corporations whose stock is held in trust as collateral for the ADR. These securities serve a dual purpose: they enable firms incorporated in these regions to raise funds in developed capital markets without having to meet the stringent listing requirements of U.S. stock exchanges, and, at the same time, enable global investors to earn returns on securities listed on these exchanges without the dual inconvenience of having to deal with time difference between countries and with currency conversion. This study examines the nature of African and Middle Eastern ADRs, sorted on basis of depositary bank, sponsorship status, industry classification, and stock exchange on which the security is listed. Data are obtained from the Bank of New York Mellon and CRSP. The intent of the study is to provide documentation to international investors who would like to hold ADRs from Africa and the Middle East in their global portfolios. The study should be of interest to international investors, managers of mutual funds who are exploring opportunities to diversify their global portfolios, managers of corporations who are planning to sponsor the issue of depositary receipts, and to bank managers who provide international financial services.
The primary securities that underlie an ADR may be corporate stocks or bonds. The earliest ADRs (1927) were issued at the request of institutional investors. These ADRs are "unsponsored." Most of the ADRs that are currently listed are "sponsored" programs, issued at the request of the firm whose securities underlie the ADR. When a sponsored ADR is issued, there may or may not be a corresponding creation of new capital. There are four grades of sponsored ADRs. Level I ADRs are traded in the OTC market. Level II ADRs trade on national stock exchanges (such as the NYSE). If new capital is raised during the process of issuing sponsored ADRs, then the ADRs are categorized as Level III and IV. Level III ADRs are listed on national stock exchanges. Level IV ADRs are privately listed, and are usually issued under rule 144A of the US Securities and Exchange Commission.
This study examines the nature and performance of ADRs on African and Middle Eastern companies. The rest of the paper is structured as follows. Section 2 reviews the literature on ADRs and summarizes pertinent studies in the area of modern portfolio theory. Section 3 examines the sponsorship status, choice of depositary bank, industrial classification, and market listing. Section 4 evaluates the performance of these ADRs on a risk-adjusted basis, using the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) Index as a benchmark for comparison purposes. Section 5 concludes the paper.
Different techniques have been used in portfolio performance measurement over time. Recently, Modigliani and Modigliani (1997) did some pioneering work in the area of financial reward and risk. They proposed a new risk-adjusted performance measure (hereafter referred to as, M Squared), which is intuitively quite appealing to investors. The idea that underlies their methodology is to adjust the returns of a portfolio to the level of risk in an unmanaged stock market index and then measure the returns on the risk -matched portfolio. Separately, academicians and practitioners in finance have shown an interest in downside risk measures for evaluating portfolio performance. The most widely cited performance measure that adjusts for downside risk is the Sortino Ratio (Sortino and Price, 1994). In this paper, we use a modified Sortino Ratio that was introduced by Pedersen and Satchell (2002), who show that this ratio has a sound theoretical foundation.
Academics have studied the benefits of global diversification of investment portfolios extensively. Solnik (1996) presents an excellent summary of these benefits. Officer and Hoffmeister (1987) show that portfolio risk can be reduced significantly by including ADRs in a portfolio of purely domestic (U.S.) securities. Aggarwal, Dahiya, and Klapper (2005) analyze the investment allocation decision of mutual fund managers to invest in emerging market firms that are listed in their domestic markets and have issued ADRs in the U.S. as well. They find that ADRs are the preferred mode of holdings if the local market of the issuer has weak investor protection, low liquidity and high transaction costs, and if the firm is small and has limited analyst following.
The predictability of stock returns in emerging markets has been demonstrated widely. Aras and Yilmaz (2008), for example, report evidence on 12 emerging market countries including two of the sample countries in this paper: South Africa and Turkey. Obi, Sil, and Choi (2010) also study the South African stock market and document that traditional analytical approaches resulted in poor value-at-risk forecasts during the 2008-2009 global financial crisis. Instead they obtain more realistic value-at-risk estimates by accounting for the effects of time-varying volatility in portfolio returns. Similarly, Muzindutsi and Niyimbanira (2012) examine the exchange rate risk exposure in the South African stock market and the pricing of this risk. They find the exchange rate exposure to be identifiable and yet different across companies.
The motivation for cross-listing shares on foreign exchanges has also been widely researched (Saudagaran, 1988). Umutlu, Salih, and Akdeniz (2007) investigate the consequences of cross listing in emerging markets and find that ADR listing has no effect on the volatility of the underlying stock. On the other hand, Jaiswal-Dale and Jithendranathan (2001) report that the ADRs capture the fluctuations of both the domestic and U.S. markets.
The relation between the price of ADRs and the underlying shares has also been studied thoroughly (Alexander, Eun, and Janakiramanan, 1987; Alexander, Eun, and Janakiramanan, 1988). Jayaraman, Shastri, and Tandon (1993) study the impact of international cross-listings using ADRs. Because ADRs can be exchanged for the underlying shares, financial arbitrage usually ensures that the price of an ADR is within transactions costs of the price of the underlying share. Interestingly, Eichler and Maltritz (2008) model the probability of a currency crisis as a function of the deviation of the ADR price from the price of the underlying stock.
To the knowledge of the authors, this is the first study of the nature and performance of ADRs on African and Middle Eastern firms, particularly, their sponsorship status, industrial classification, names of banks that are active in this business, and exchanges on which these ADRs are listed. This is also the first rigorous study of the returns that have accrued to these ADRs, from the point of view of U.S. based investors. The results of this study should be of interest to investors and mutual fund managers who are looking for opportunities to diversify their international portfolios, to managers of African and Middle Eastern firms who are contemplating sponsoring the issue of these securities in U.S. markets, and to the managers of banks, which provide international financial services.
NATURE OF AFRICAN AND MIDDLE EASTERN ADRS
As of January 2012, there are 75 ADR issues on firms in the Sub-Saharan Africa (SSA) region and 58 ADR issues on firms in the Middle East / North Africa / The Gulf (MENAG) region. 74 ADRs in SSA are from South Africa and one from Zambia. 26 ADRs from MENAG are in Turkey, 22 in Israel, five in Egypt, two each in Jordan and United Arab Emirates, and one in Lebanon. 68 ADRs are sponsored and 65 are unsponsored. Regarding the financial institutions that have issued the ADRs, the Bank of New York Mellon accounts for 119 of these issues, followed by Deutsche Bank with 29 issues, Citibank with 28 issues, and J.P. Morgan Chase with eight issues. Regarding the exchanges on which our sample ADRs are listed, seven each are listed on the NYSE and NASDAQ, 1 16 are listed on OTC (other than NASDAQ), and the other three are listed on OTCQX.
With respect to industrial classification, 23 of the ADRs are in the mining industry; 16 in the banking industry; 10 in general retailers; 7 each in construction and materials and financial services; 6 each in media, mobile telecommunications, oil and gas producers, and pharmaceuticals and biotechnology; 5 in food producers; 4 in industrial metals and mining; 3 each in automobiles and parts, chemicals, general industrials, and personal goods; 2 each in food and drug retailers, forestry and paper, health care equipment and services, household goods and home construction, industrial transportation, life insurance, and real estate investment and services; and 1 each in aerospace and defence, beverages, electronics and electric equipment, equity investments and instruments, fixed line telecommunications, industrial engineering, oil equipment, services, and distribution, software and computer services, support services, technical hardware and equipment, and travel and leisure. All data are obtained from the website of the Bank of New York Mellon.
PERFORMANCE OF ADRS ON STOCKS FROM AFRICA AND THE MIDDLE EAST
Data and Methodology
Monthly return data for the three-year period January 2008 - December 2010 are obtained from CRSP. CRSP has full return data for seven South African ADRs, five ADRs from Israel, and one Turkish ADR. Therefore, the final sample in this study for the performance analysis consists of 13 ADRs. The return on U.S. 4-week Treasury Bills is used as the proxy for the risk-free rate. The MSCI EAFE Index is utilized as the market benchmark.
Monthly returns are averaged over the three-year period to obtain the Mean return. Risk-free rate of return is subtracted from the mean return to compute the Mean excess return. Mean excess return of each ADR is divided by its standard deviation to compute the Sharpe measure:
where Ri = mean return on ADR i,
Rf = mean risk-free rate of return,
oi = standard deviation of returns for ADR i.
Mean excess return of each ADR is divided by its beta to obtain the Treynor measure:
where ßj is estimated from the market model:
where Rmt = market return during period t,
eit = error term.
Expected return of each ADR is subtracted from its actual mean return to compute Jensen's Alpha:
where the expected return for each ADR is obtained using the Capital Asset Pricing Model:
E[Ri] = Rf+^i(Rm-Rf)
Jensen's Alphas are then tested for statistical significance.
Mean excess return for each ADR is divided by the downside deviation ofthat ADR' s return from the risk-free rate of return to compute the Sortino Ratio:
where the downside deviation is estimated as follows:
Sharpe measure is multiplied by the market standard deviation and then the risk-free rate added to calculate the M Squared measure:
Finally, the benchmark standard deviation is divided by the ADR standard deviation to obtain the Leverage Factor:
The 13 ADRs with full monthly return data are identified in Table 2 along with their risk, return, and performance statistics. Returns, of course, are reported in US dollars. The ADRs are ranked in alphabetical order. The ADR with the highest mean return is Formula Systems-1985 of Israel with an average monthly return of 3.60 percent. In comparison, the monthly mean return of the benchmark MSCI EAFE Index is -0.26 percent. The ADR with the highest total risk (measured by the standard deviation of returns) is DRDGOLD of South Africa with a monthly standard deviation of 20.10 percent. In comparison, the standard deviation of the benchmark MSCI EAFE Index is 8.06 percent. Further, Table 2 reports the numerical values of the Sharpe and Sortino measures, which are used to rank the ADRs in Table 3. The highest Sharpe and Sortino measures obtained (0.29 and 0.50) are by Formula Systems-1985. In comparison, the Sharpe measure and the Sortino measure of the benchmark MSCI EAFE Index are -0.04 and -0.05, respectively.
Table 2 also reports the values of ADR Betas, M Squared measures, Jensen's Alphas (and their tstatistics), and Treynor measures, all of which are computed using the benchmark MSCI EAFE Index. The ADR with the highest systematic risk (Beta=1.70) is Sappi of South Africa. In comparison, the Beta of the benchmark MSCI EAFE Index is, by definition, exactly 1.00. The ADR with the highest M Squared measure (2.41) is Formula Systems- 1985. In comparison, the benchmark MSCI EAFE index has an M Squared measure of -0.26. The ADR with the highest Alpha measure is Formula Systems-1985 with Alpha equal to 3.83. None of the ADR Alphas are significant at the five percent level. The Alpha measure of the benchmark MSCI EAFE Index is, by definition, zero. Finally, the ADR with the highest Treynor measure (7.68) is Randgold Resources of South Africa. In comparison, the Treynor measure for the MSCI EAFE Index is -0.30.
Table 3 reports the rankings of all the ADRs. The Sharpe and Sortino ranks indicate that all 13 ADRs have returns (adjusted for total risk and downside risk) that exceed the risk -adjusted returns of the MSCI EAFE Index. The Treynor and Alpha ranks in Table 3 indicate that 12 ADRs have returns (adjusted for systematic risk) that exceed the risk-adjusted returns of the MSCI EAFE Index. The only ADR underperforming the Index is Turkcell Iletisim Hizmetleri of Turkey. The ranking based on the M Squared measure is identical to the ranking based on the Sharpe measure. However, the M Squared measure enables us to draw some inferences, which cannot be drawn from the Sharpe measure and these are detailed at the end of this section.
Table 4 reports the average returns that accrue to the whole sample of ADRs with and without riskadjustment. The risk-adjustment is performed by using the MSCI EAFE Index as the benchmark. The returns are annualized for the convenience of investors. This is done by compounding the monthly mean returns over twelve periods. In that table, Alon Holdings - Blue Square Israel, which ranks sixth based on unadjusted returns, falls back to rank nine on the basis of returns adjusted for risk. On the other hand, Partner Communications of Israel, which ranks eighth on an unadjusted basis, ranks third when the returns are adjusted for risk. More strikingly, Teva Pharmaceutical Industries of Israel ranks 11th on the basis of unadjusted returns, but ranks fifth based on returns adjusted for risk. The leverage factor for this ADR is 1.74, which implies that an investor, who is comfortable with bearing the same level of risk as in the benchmark MSCI EAFE index, could lever the ADR (borrow 74 percent, if possible, at the risk-free rate of interest and invest all in the ADR) and thereby attain an annual return level of 1 1.16 percent. The example below details how this return is obtained.
Consider an investor who would like to earn superior returns on an ADR and, at the same time, bear only an average level of risk. In this context, the average level of risk is measured by the standard deviation of the benchmark MSCI EAFE index, which is 8.06 percent on a monthly basis. Now consider the following investment strategy: Suppose that the investor has $1,000 to invest. The investor could borrow $740 and invest $1,740 in Teva Pharmaceutical Industries. The end of month return from the ADR portion of the portfolio will be $1,740 ? 0.0053 = $9.22. Suppose that the borrowed funds were loaned at the monthly risk-free rate of 0.04 percent. In that case, the borrowed funds will cost $740 ? 0.0004 = $0.30. The portfolio return is $9.22 - $0.30 = $8.92, which is a return of 0.89 percent on a monthly basis or 1 1.22 percent (slightly off the 11.16 percent in Table 4 due to rounding) on an annual basis. Note that the monthly risk of the portfolio is 1.74 ? 4.62 = 8.04 percent (again slightly off the 8.06 percent in Table 2 due to rounding), which is the same as the monthly standard deviation of the benchmark MSCI EAFE Index. This investment strategy, therefore, enables the investor to earn superior returns for an average level of risk. It may be noted that the above example assumes that the returns on risk-free US treasury bills are not correlated with the returns on the ADR.
COMPREHENSIVE POLICY/MANAGERIAL IMPLICATIONS
This study has clear managerial implications for corporate treasury managers in developing economies. There may be firms located in Africa and the Middle East whose ability to raise capital is constrained by the limited size of the local stock market. One possible way out of this constraint is to issue shares in the local stock market, present a credible business plan to an international bank and then request the bank to hold the shares in trust and create a sponsored ADR which is subsequently traded in a developed stock market such as the US. By using this technique of financing, the ability of the issuing company to raise capital is not constrained by a relatively small local stock market.
Investors who would like to diversify their global portfolios would do well to examine investment opportunities in Africa and the Middle East. In particular, stock markets in South Africa, Saudi Arabia, Turkey, Israel, Qatar, Kuwait and the United Arab Emirates have a range of investment opportunities and market depth. A convenient way to access these markets would be via ADRs which are issued and traded in the US but are based on firms in this region. These ADRs vary widely in terms of their risk and return, as documented in this study. However, the risk-adjusted returns of some of these ADRs can be quite attractive and is superior to the return on a benchmark international stock index such as the MSCI EAFE. For investors who seek level of risk no higher than the benchmark index, this study presents a technique of lowering the risk of a portfolio by holding the ADR in combination with a risk-free security such as a treasury bill.
Finally, for managers of financial institutions, there is a clear opportunity to diversify operations by providing financial services to a historically underserved region of the world which has a large untapped potential for economic growth. These managers may want to evaluate business plans from firms based in Africa and the Middle-East with a view to creating sponsored ADRs based on shares of these firms. This activity will not only result in providing much needed capital to firms from developing nations but will also provide fee income for financial services provided by international banks. In many cases the reputation of the issuing bank will facilitate the acceptance of these ADRs by the investing public in the US and other developed financial markets.
ADRs represent a convenient investment vehicle to access markets in Africa and the Middle East for international investors who are contemplating purchase of stocks listed in those markets. These securities are useful in two ways. First, they enable global investors to earn returns on African and Middle Eastern stocks without the dual inconvenience of having to deal with time difference between countries and currency conversion. Second, they allow firms incorporated in Africa and the Middle East to tap U.S. capital markets without having to meet the stringent listing requirements of U.S. stock exchanges. There are 133 ADRs from Africa and the Middle East that are listed on U.S. markets, and hence the investors have a wide range of choice of companies across diverse industry groups. This study examines the nature of these ADRs with emphasis on identifying the depository bank, sponsorship status, industry classification, and market listing.
Prior research has reported the performance of individual African and Middle Eastern stocks in local currencies. However, risk-adjusted returns reported in terms of US dollars would be more useful to international investors for, both, security selection and portfolio construction. In addition, from these investors' points of view, the instrument of choice for accessing African and Middle Eastern stock markets is the ADR, not the underlying stock itself. Hence, there is need for rigorous evaluation of the performance of ADRs using measures based on modern portfolio theory. There is extensive documentation on the performance of U.S. based stocks, especially for the S&P 500 index components. Consequently, this study serves as an important complement to the existing literature on the construction of global portfolios.
In order to facilitate comparison with international stock markets, this study uses the Morgan Stanley Capital International EAFE Index to evaluate the risk-adjusted performance of African and Middle Eastern ADRs. Some of these ADRs have unadjusted returns which are high, but once risk is factored in, the adjusted returns do not appear to be very attractive. On the other hand, some ADRs with modest returns may be quite remunerative to international investors, when their returns are adjusted for risk. Global investors may want to examine each of these securities in detail, in order to evaluate them further for possible inclusion in an investment portfolio. Of course, the contribution of a security to their portfolio return and their portfolio risk matters more to the global portfolio investors than the return and risk of the individual security.
This study provides initial evidence on the risk and return characteristics of ADRs from Africa and the Middle East. It would be beneficial to update this information on a continuing basis, in order to provide documentation to international investors who have a desire to diversify into this market, but are not sure of which ADRs they would like to select. Future research may focus on decomposing the return to these ADRs into its two components: the financial performance of the underlying firm and the fluctuations in the exchange rate.
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Onur Arugaslan received his Ph.D. in Finance from the University of Texas at Dallas and is an Associate Professor of Finance at Western Michigan University. His research includes the separation of cash flow rights and voting rights, the endogeneity of liquidity, the risk-adjusted performance of American Depository Receipts, and the market reaction to the acquisitions by unified dual class firms. Arugaslan has published articles in various journals including the Journal of Finance and the Journal of Corporate Finance.
Ajay Samant, Ph.D., Indiana University, serves as Dean and Professor of Finance at the University of North Florida. His published research includes the areas of international financial markets, performance evaluation of mutual funds and interest rate swaps. He has served as keynote speaker at international business conferences and has been interviewed on national television for expert opinions in the areas of banking and financial markets.…
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Publication information: Article title: Performance Evaluation of American Depositary Receipts on Stocks from Africa and the Middle East. Contributors: Arugaslan, Onur - Author, Samant, Ajay - Author. Journal title: Journal of Global Business and Technology. Volume: 8. Issue: 2 Publication date: Fall 2012. Page number: 38+. © Global Business and Technology Association Fall 2008. Provided by ProQuest LLC. All Rights Reserved.
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