American Depositary Receiptshave been a staple of larger investment portfolios since the mid-1990s when ADR—only separate account strategies were popularized by the brokerage industry in the United States. By definition, ADRs are securities listed on U.S. stock exchanges that represent shares of foreign companies held by a depository bank. They trade in U.S. dollars, they've been assigned a ticker symbol and they must conform to U.S. accounting and regulatory standards. Investors in ADRs benefit from the relative simplicity of trading as well as lower execution and custodial costs.

But for as long as ADR-only strategies have existed, consultants and other specialists in due diligence have debated their efficacy. The question essentially has been whether ADR-only strategies (which are typically deployed in separately managed accounts) are unduly hampered in their ability to generate alpha compared to similar mutual fund strategies that use "ordinary shares" (shares trading on foreign exchanges in their local currencies).

The crux of this debate is the issue of supply. Consider this: The Russell Global ex-U.S. Index includes approximately 7,000 foreign securities while the number of listed ADRs at midyear 2008 was only 429. In addition, the number of listed ADRs has been declining for the past five years, in no small part due to the increased burdens imposed by Sarbanes-Oxley. Granted, there are a good number of unsponsored, over-the-counter ADRs in the marketplace, but once liquidity is taken into consideration, the number of viable securities has been less than 400.

Given the limited nature of the opportunity set available to ADR-only strategies, their results might be less impressive than strategies that can trade both ADRs and ordinary shares. But I'll not tackle that issue here. Instead, I'll provide an update on the changing environment for ADR-only strategies; changes that may make the performance question less relevant.

On Oct. 10, 2008, the U.S. Securities and Exchange Commission issued an amendment to Section 12(g) of the Securities Exchange Act of 1934, the passage that requires foreign issuers to submit written applications to register equity securities. Essentially, the amendment exempts from the Act's requirements certain foreign issuers, specifically those companies that maintain a listing of their equity securities in their primary markets and provide specified information on their websites.

The impact of this ruling on the ADR marketplace was brisk. On Oct. 27, The Bank of New York Mellon issued a press release stating that, in light of the change, the bank had established more than 200 new unsponsored ADRs. The release noted that "...Michelin, BMW AG, El Al Airlines, and Nippon Oil are just a few of the new ADRs that both U.S. retail and institutional investors will now be able to hold in their portfolios as dollar-denominated securities."

Spotlight Manager: Thornburg Investment Management—International ADR

Thornburg Investment Management is an independent, employee-owned investment management firm located in Santa Fe, N.M. The firm manages domestic equity, international equity, and fixed-income separately managed accounts and mutual funds for institutional and high-net-worth clients. The management team employs a consistent, repeatable, bottom-up approach to uncover promising international companies with sound business fundamentals at a time when their intrinsic value is not fully recognized by the market.

Portfolios typically hold 40 to 50 securities and are built from three buckets of stocks: basic value, consistent earners and emerging franchises. Basic value stocks are those selling at low valuations relative to a company's net assets or earning power. Consistent earners have steady earnings and dividend growth, and are priced below historical norms. Emerging franchises are value-priced companies expected to grow at above-average rates.

Thornburg believes that these three categories provide meaningful diversification that can benefit clients in a variety of market environments. Our evaluation of the strategy indicates that Thornburg has been able to generate positive alpha on a consistent basis since inception.

Randy Dry, managing director of Thornburg, says that his firm is pleased with the SEC rule change. "It has given U.S. investorsadditional opportunity to investoverseas.... With increased globalization and interest in the foreign markets, the rule change willhelp meet increaseddemand for foreign investing."

Dry adds that the ADR universe is also expanding. "We are excited toseeADRs from companies we couldn't previously own in our ADR-only strategy.We know many of these companies very well and have owned their ordinary shares inother strategies-now we have the ability to own them in our International ADR strategy."

There are still some unresolved issues with regard to managing ADRs that would dampen the effect of the rule change. Indeed, Dry says that liquidity is the primary concern. Many of the new ADRs aren't sponsored and they don't trade very well in the U.S. "In order to gain liquidity, we access the local markets and convert ordinary shares to ADRs. Larger institutions and money managers are able to do this, but the individual investor probably can't.The downside to the individual investor is a large spread between bid and offer, something that we avoid by trading in the local markets."