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By Scott Burns | 07-27-2010 02:28 PM

The Marriage of ETFs and ADRs

Bank of New York Mellon's Julio Lugo examines the expanding relationship between ADR and ETFs.

Securities mentioned in this video
EEB Guggenheim BRIC ETF
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Scott Burns: ADRs and ETFs, two great structures coming together. Hi there, I'm Scott Burns, director of ETF research. Joining me today is Julio Lugo, vice-president of index products with Bank of New York Mellon. Julio, thanks for joining me.

Julio Lugo: Thanks for having me, Scott.

Burns: Let's talk about, first of all, indexes of ADRs. What's available out there for investors right now?

Lugo: Sure. The Bank of New York actually created the first ADR index in 1998, which was called the ADR Index. And since then, we've been able to create three additional families of indices: the GDR Index, a DR Index, as well as the ADR Classic Index. Last year we created what's called the ADR Composite Index. So now we have 140 indices representing the ADR market.

Burns: Let's back up on some of the acronyms you used there. GDR is a....

Lugo: Of course. The ADR Index represents those ADRs that are traded on the New York Stock Exchange, the New York Stock Exchange AMEX, as well as NASDAQ. The GDR Index represents those DRs that are traded on the London Stock Exchange as well as some other European stock exchanges.

Burns: OK, so that's the European version of what we know as the ADR.

Lugo: Those are for qualified institutional buyers off-shore. Then what we created was a DR Index, which brings together the listed ADRs, those form the ADR Index and well as the GDR Index. And then finally the ADR Classic Index is an index that brings together the listed ADRs, as well as acknowledging those ADRs that trade OTC. And there's about 1,800 of those securities.

Burns: So why would someone be interested in an ADR index? We were chatting a little bit earlier and I said, well, isn't that going to give you some weird sector weightings and thigns like that? Why are people interested in these products?

Lugo: Institutional demand for ADRs has grown tremendously over the years. In fact, in the past 10 years we've seen portfolio holdings grow from 10 percent to 26 percent. What we wanted to brings, as the largest depositary in this business, we wanted to bring them a relevant index so that they can match apples with apples and oranges with oranges. And if they're truly an ADR investor, a benchmark to an ADR index.

Burns: Wow. I think another reason where we see that interest too, is although a lot of folks want to hold international securities, it's kind of cumbersome sometimes to buy them directly on those exchanges. The ADR is a different, more investable universe for them.

Lugo: When you investing with an ADR, you're getting cost, convenience, and accessibility. You're trading and settling with a U.S. security, so it follows all SEC rules and regulations. Corporate actions. Dividends are paid to you in U.S. dollars. Your information comes to you in English. So you really do get the benefits of the U.S. security at the end of the day, with accessing those foreign markets.

Burns: All right, now let's talk about what I'm really interested in, and that's ETFs, and ETFs and ADRs and where they really come together. I don't think a lot of investors are aware even though our mantra is "know what you own, know what our own" are aware of the fact that there are a lot of ETF products out there that really are specifically owning ADRs and other depositary receipt-type securities.

Lugo: That's true. And in our case, with the Bank of New York indices, we now have 14 ETFs that are benchmarking or tracking the Bank of New York Mellon ADR indices. The first ETF that came to the market were the Builders, through the folks at Invesco PowerShares back in 2002. Since then, we had with the folks at Claymore Securities the first BRIC product in 2006, which was wildly successful, as well as the first frontier markets. And when you look at those two ETFs, we look at the bid ask spreads, that are trading between three to five cents on the BRIC, as well as the frontier within 10 cents, that says a lot, I believe, to the index itself.

Burns: I would say one thing, tracking error has been very much in the headlines right now, and we're going to crunch more numbers on it in general just for our purposes. But I'd be inclined to think that investors that are really concerned about tracking error, where it's really been occurring has been in a lot of these emerging market-themed indexes where they've had to use sample portfolio construction and they've got market timing issues. But through the construction of an index using ADRs, I think that ends up solving a lot of those issues. I'd expect that you guys have had pretty good tracking error.

Lugo: The tracking error has been within five basis points, especially on the frontier, and even better on the BRIC. But nonetheless, again, all those efficiencies that come from the ADR relay through the ETF, especially even through the expense ratios.

Burns: Right. So all these ETFs that we're talking about right now are really more passive. They're following indexes and some of them are a little more sophisticated or niche than others. But the next leg of the ETF/ADR marriage is about to begin, and you guys are partnering with another firm to launch an active ADR fund. Talk about that a little bit.

Lugo: Sure. Absolutely. We're very excited about this project, because this is a culmination of many years of work, many years of working with our partners, and brining accessibility to ADR investors. Here, in the case of WCM and Bank of New York Mellon ADR Focused Growth ETF, we will have ADRs from both the listed and OTC. So referencing the Bank of New York Classic Index. WCM had a tremendous track record. Traditionally their funds have been institutionally managed, so this gives access to the individual investor.

Burns: Besides access to the individual investor, what do really hope for this active foray into ETFs of ADRs? What do you think will come of this?

Lugo: I'm a big believer in the active ETF, and I think there'll be many more to come. But again, when accessing the foreign markets, the ADR will bring these efficiencies, especially to the APs and the market makers, so they can trade and settle these efficiently, which will reflect in the pricing and the NAV of the ETF.

Burns: Julio, thanks for joining me. I think ETFs and ADRs have all the same - when you describe the two - transparent, liquid, low-cost, efficient. You could put them on a piece of paper and not know if you were talking about ADRs or ETFs some of the time.

Lugo: A happy marriage.

Burns: Definitely, definitely. Wish you the best of luck with your indexes, and with the new active fund.

Lugo: Thank you very much.

Burns: And again, thank you very much for stopping by.

Lugo: Thank you.

Burns: I'm Scott Burns, Morningstar's director of ETF research. For this and other ETF research commentary, please check out Morningstar.com and Morningstar's ETFInvestor Newsletter.

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