Though the New York Stock Exchange and the NASDAQ soak up most of the world’s investing attention. Stocks listed on foreign exchanges have a ton of potential as well. But if your broker doesn’t offer access to foreign exchanges, how can you invest in companies that aren’t based in the U.S.?
American Depository Receipts (ADRs) can allow you to invest in a foreign stock without creating a special international brokerage account. While simpler than finding a broker to trade on international exchanges, ADRs do trade a bit differently than standard shares of stock.
Today, we’ll learn a little more about ADRs, how they work, and how they vary from standard shares of domestic stock.
American Depository Receipts Explained
What does ADR stand for? “ADR” stands for “American Depository Receipt.” A depository receipt is a certificate issued by a bank signifying that a bank owns a certain foreign stock. ADRs are negotiable, which means that they can be bought and sold.
What is an ADR? An ADR is a certificate that represents a foreign company but trades on a U.S.-based exchange like the New York Stock Exchange. ADRs trade in basically the same way as stocks, being bought and sold throughout the day by traders.
ADRs were introduced to allow American investors to invest in international companies without going through the hassle of opening a foreign brokerage account, dealing with varying currency exchange rates and navigating time zone differences between exchanges.
Since ADRs are issued by U.S. banks, this means that they’re priced and pay dividends in USD. As the owner of an ADR, you may or may not have the standard voting privileges that come with owning a share of stock depending on the type of ADR.
Types of ADRs
There are two types of ADRs – sponsored and unsponsored. A sponsored ADR negotiates directly with a U.S. bank in order to issue certificates. The company issuing a sponsored ADR will usually take care of the costs of issuing the ADR. Meanwhile the bank handles investor negotiations. ADRs are further broken up into three levels. These are based on the extent to which the company issuing the ADR has complied with U.S. SEC regulations.
Lets dive into the various levels of sponsored American Depository Receipts and see how they differ.
Level I ADRs
The most basic type of sponsored ADR and aren’t listed on public exchanges and have the loosest requirements from the SEC. This level can be used to establish a trading presence on the U.S. market but not to raise capital. The only way to purchase a Level I ADR is through an over-the-counter market with a sponsoring bank.
Level II ADRs
Level II ADRs must meet slightly higher SEC regulations, but they cannot be used to raise capital. The Level II ADRs may be listed on more exchanges and receive more visibility to U.S. traders.
Level III ADRs
The Level III ADRs must meet the highest SEC standards and are subject to the same reporting standards as public companies listed directly on U.S.-based exchanges. Only Level III ADRs may be used to raise capital for a foreign company.
Unsponsored ADRs have no direct involvement from a foreign company and are created and issued solely by banks purchasing and distributing shares of foreign stocks. An unsponsored ADR doesn’t need to meet any specific SEC standards and never include voting rights. An unsponsored ADR may or may not meet the requirements to be considered Level I.
ADRs vs Regular Stocks
It’s very important to remember that an ADR isn’t the same thing as owning a share of a foreign stock. An ADR isn’t itself a share of stock — it’s a certificate issued by a U.S. bank or other custodian that represents the stock of a foreign company.
ADRs aren’t necessarily a one-to-one stock ratio. A single ADR may represent the rights to a single share of foreign stock, ten shares of a foreign stock, or a fraction of a share.
Let’s take a look at an example to further illustrate this point. Imagine that you want to invest in Company X, which trades on a foreign market. Company X’s stock is currently worth $.50 a share.
A foreign branch of a U.S. bank might purchase 100 shares of Company X’s stock, bundle them together, and sell them as an ADR for $50. If you aren’t careful, you might not realize that a single share of Company X’s stock isn’t worth $50.
Things to Consider Before You Trade American Depository Receipts
As you can see, trading an ADR and trading stocks isn’t exactly the same. Let’s take a look at a few considerations you’ll need to make before you begin investing in ADRs.
Investing in an ADR is significantly more complicated than investing in common stock. When you purchase a share of common stock on a U.S. exchange, you know that the stock has met minimum SEC financial documentation requirements. When you invest in an ADR, you may not have access to SEC documentation depending on the level of the ADR you’re investing in.
ADRs may also represent multiple stocks, a fraction of a stock or a single share of stock. There are multiple layers of consideration you need to account for when you decide to purchase an ADR. It’s a good idea to hold off on buying ADRs until you can buy and sell U.S. common stock with confidence.
Exchange Rate Risk
In addition to the standard inherent risks that come along with investing in a security, ADRs also face additional currency-based risks. If the value of the issuing country’s currency drops in relation to the U.S. dollar, the value of your ADR will drop as well.
The value of your ADR may also be influenced by inflation of the base currency. Changes in political leadership that affects the local markets of your ADR’s base country could be an influencing factor as well.
This can make ADRs a more volatile investment than standard shares of common stock listed on U.S. exchanges. This is especially true if your ADR’s correlating stock is listed on a developing country’s exchange.
Taxes on ADRs
ADRs are also taxed differently than common stock. You’ll still need to pay the same capital gains taxes and dividend income taxes on ADRs that you would pay on shares of U.S.-based common stock.
However, you must also pay dividend taxes levied by foreign governments on stocks issued in their country. A certain percentage of the dividend you earn on ADRs may be withheld by your broker depending on the ADR’s country of origin.
Every country has its own tax laws and tax relationship with the United States. Select tax treaties may mean that you owe less in taxes or are exempt for foreign taxes. A tax expert may be able to help you navigate your tax burden when you begin investing in ADRs.
Some ADRs charge “pass-through” fees to compensate the custodian of the ADR for managing the certificate. If your ADR does charge a pass-through fee, it will usually be between $0.01 and $0.03 USD per share. Your broker might deduct this fee from your ADR’s dividend. Or it might charge it as a separate fee to your brokerage account.
Personal Risk Tolerance
Ultimately, the decision to invest in an ADR or a stock will come down to your personal risk tolerance. ADRs — especially unsponsored ADRs — can come with many more risks than stocks. This is because they aren’t necessarily bound to the same SEC rules and regulations as common stock listed on U.S. exchanges.
ADRs may be exceptionally more volatile than stocks as well consider the risk of inflation and currency exchange rate fluctuations. If you’re not prepared to shoulder a higher level of volatility, you may not want to invest in ADRs.
How To Trade ADRs
Do you think that ADR investing might be right for you? Let’s take a look at how you can get started by purchasing your first ADR.
Step 1: Open an Account
Like purchasing any other security, you’ll need to open a brokerage account before you can buy ADRs. Look for a brokerage that is registered with both the SEC and FINRA and insures your cash and securities within your account.
Step 2: Choose Which ADR You Want to Buy
Once your account is open and you’ve linked a payment method, it’s time to choose which ADR you’d like to invest in.
Start by comparing ADRs by level. If you’re the type of investor who typically invests in highly volatile and less expensive assets, you may want to purchase Level I or Level II ADRs. If you’re a newer investor or an investor who typically invests in more stable assets, browse Level III ADRs.
You may want to begin by researching ADRs that you’re already familiar with. Major international companies like Vodafone, Nokia, British Petroleum (BP) and Royal Dutch Shell are household names that trade as ADRs.
Beginning with a solid company with a business you understand can be an excellent way to dip your toes into the waters of ADR investing. As you gain more familiarity with the ADR structure, pricing, and taxation models, you can branch out to more obscure companies.
Step 3: Place a Buy Order With Your Broker
ADRs trade on exchanges like stocks. If you’ve purchased a share of stock before, you’ll follow the same process to purchase an ADR. Place a buy order using your broker’s platform and wait for your order to be filled. Once your order is filled, you’ll see your ADR in your brokerage account.
Diversifying Your Portfolio With ADRs
American Depository Receipts and the stocks they represent can be full of potential. This allows the investor to quickly and easily explore a foreign market. However, they can also represent a higher level of risk. They don’t need to follow all the same SEC regulations and rules as shares of common stock.
Before you invest in an ADR, be sure that you understand the basic differences between the levels of ADRs. You need to research the currency and inflation risks that come inherent with these securities. In addition to that, be wary of the fees and taxes you’ll pay.
When purchased by an experienced and knowledgeable investor, ADRs can add an excellent level of diversification to your portfolio. As always, feel free to contact a financial advisor if you need help investing in American Depository Receipts.