When Is An ETF Not An ETF?

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It’s not often I read an SEC filing and then swear under my breath. Last week’s filing by Precidian, however, had me nearly throwing things.

Don’t get me wrong—I actually think the folks at Precidian are some of the smartest guys in the ETF space. They’re a kind of ETF product structure think tank, and in one way or another, they’ve been behind some of the more interesting product developments in the market, from the SPDR Gold Trust (GLD | A-100) to the Guggenheim CurrencyShares products to the raft of nontransparent active filings we’ve been covering here at ETF.com.

So what’s got me pulling my hair out? It’s an idea called “ADRPLUS.” It’s simple. It’ll work. I’m annoyed I didn’t think of it first, and it’s going to make my job harder.

Don’t bother Googling it; the only place you can read about it is in the SEC filing. At its core, it’s simple. It takes the currency hedging trend kicked off by the WisdomTree Japan Hedged Equity ETF (DXJ | B-65) to a logical extreme. The basic investing logic works like this:

As a U.S. investor, if you want exposure to the performance of the Japanese stock market, you actually have to make two transactions. The first is you have to sell your dollars to buy yen. Then you take those yen and you buy stocks in Tokyo.

When you buy a fund like the iShares MSCI Japan ETF (EWJ | B-97), that’s what you’re essentially doing. The issue is, now you have two exposures. If the Japanese stock market is flat, but the yen depreciates in value, then you actually lose money. After all, if you bought 100 yen for each dollar going in, and now it costs 120 yen to buy back your dollar, well, you’re down 20 percent just for the currency transaction.

That was the reason for DXJ’s meteoric rise in 2013—it still went and bought Japanese stocks, but it also hedged out the risk of a depreciating yen—in a year where the yen depreciated a lot.

Precidian’s ADRPLUS filing takes this to the extreme—single stocks. Consider the BNY Mellon Toyota Motor Corp ADRPLUS anticipated in the filing. It buys a single security—the Toyota ADR that trades on the NYSE under the symbol TM. You can think of TM as the equivalent of EWJ in this case. It’s a U.S.-dollar version of Toyota stock. It then puts on a currency hedge to get rid of the yen exposure.

Why would you bother? The same reason you might have bought DXJ. Here’s how Toyota did last year in Japanese-market and U.S. investor terms:

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Toyota

Chart courtesy of Bloomberg

 

That top line is what you received as a local investor—a 54 percent return. As an ADR investor (in the middle), you received 33 percent. The difference is entirely explained by the 21 percent devaluation of the yen (the bottom line).

The ADRPLUS simply takes the ADR for Toyota and adds back in the currency factor.

Why use ADRs? Honestly, why not? The headache of trading on the local exchange gets the fund essentially nothing. ADRs are already highly liquid and well established, so the process of going out and setting up accounts to buy yen, then buy local stock, then put a currency hedge on top is actually more complex than just buying the ADR for the same return profile.

I can already hear the hand wringing about “but these aren’t funds!” In fact, it was the first thing Elisabeth Kashner, my director of research said to me this morning. But really, they’re just as much a “fund” as GLD; after all, it invests in a single asset too.

And I think these will be genuinely useful. Imagine a world where essentially every ADR is available this way. Constructing a currency-hedged thematic index of, say, industrial companies would be child’s play. No need to worry about hedging four Asian currencies and the euro—just fill the index with ADRPLUS shares. Or imagine you’re a hedge fund putting on a pair of trades in the auto space:Long Toyota/short GM anyone? Again, child’s play with these things.

So why am I tearing my hair out? I’m in the business of analyzing ETFs. It’s really the whole point of ETF.com. The ADRPLUS structure is a forehead-slappingly simple way to solve a problem for (I’m guessing) institutional investors and hedge funds making specific stock plays. My hat’s off to them.

But there are thousands of ADRs listed on U.S. exchanges. If the ADRPLUS concept works, and catches on, the relative simplicity of the structure would mean that the product proliferation could be intense.

I supposed I’ve got some time before we have to worry about it, but figuring out how to wedge a few dozen, or hundreds, or thousands of these things into the ETF universe is going to be … interesting.


At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at dnadig@etf.com .


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