Diversify your portfolio by country and industry

American Depositary Receipts, or ADRs, give you benefits. One is diversification. It’s tempting to call ADRs American ‘Diversification’ Receipts. They give you industries that Canada lacks or has in short supply.

American_Depositary_ReceiptsAmerican Depositary Receipts (ADRs) let you diversify your portfolio holdings by industry and currency, since they generate most of their sales and earnings abroad. This can let you earn more while reducing your risk.

We think ADRs have a place in most portfolios. (ADRs and US stocks should make up at least a quarter of your stock portfolio, depending upon your circumstances.) We recently rated 10 of the 34 ADRs we follow as ‘buys’.

The ADRs include companies from Belgium, China, Denmark, Finland, France, Holland, Israel, India, Japan, Mexico, South Korea, Spain, Sweden, Switzerland, Taiwan and the United Kingdom.

Some of the above are so-called ‘emerging markets’. Such markets hold the potential for faster economic growth. Some have younger populations than the industrial world. This adds to the demand for goods and services now. And in the future, they’ll add to the demand for financial assets.

Investing in emerging markets raises your risk. But many have low correlations with US stocks and with each other. This can help offset the higher risk (see below)—particularly if you buy a mutual fund diversified by country. Even so, correlations tend to rise when financial markets fall, which reduces this advantage of diversification.

Buy abroad what you can’t at home

ADRs let you buy into industries you can’t buy here. For instance, Japanese manufacturing stock Canon Corp. has no Canadian peers. It manufactures photocopiers, printers, cameras and flat-panel display screens globally. Similarly, many of the other ADRs operate in industries with few or no Canadian counterparts.

Even when you buy ADRs in the same industries as North American companies, you can comparison shop to see where you’ll get the better deal, at home or abroad. Compare consumer goods stock Unilever to US Key stock Procter & Gamble, or healthcare stocks such as drug company Sanofi to US Key stock Pfizer and so on.

Keep in mind that ADRs also protect you from weaker reporting rules in some overseas markets—because they must file their US financial statements in English using US accounting rules.

Our ADRs deliberately exclude natural resource stocks, financial stocks and some utilities. After all, the Canadian market offers lots of resource companies, financial institutions and high-yield utilities (that face no withholding tax but instead benefit from the Canadian dividend tax credit). That’s why our ADRs include more of the manufacturing stocks and consumer stocks that are harder to find in Canada.

One important thing is to consider all your portfolios (including your spouse’s) as one and strike a suitable overall balance. Use ADRs to add to the manufacturing and consumer sections of your portfolio and get the benefits that ADRs provide.

Low correlations cut risk

Another way ADRs let you reduce risk is through low correlations (or dissimilar stock price movements) to each other and to US stocks.

Canada is at the high end of the correlation range. Canadian stocks tend to closely follow American stocks. With 1.0 equal to perfect correlation, one study found a correlation of 0.82 between Canadian and American stocks.

Stocks on overseas exchanges—particularly those in emerging markets—have lower correlations with US stocks. This can let you build a portfolio that protects you from wide market swings and lets you sleep better at night.

Stocks in South Korea, for instance, had a correlation of just 0.2 with US stocks. In other words, the ups and downs of these nations’ stocks have relatively little to do with the direction of US stocks and a lot more to do with domestic matters.

But correlations rise when global stock markets fall. That is, diversification offers less just when you need it most.

As well, each emerging market typically has low correlations with other emerging markets—further reducing the risk of all your ADRs falling at the same time.

Emerging markets individually pose higher risk. Then again, they also offer higher potential growth. That is, a basket diversified by country reduces your risk.

This is an edited version of an article that was originally published for subscribers in the November 10, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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