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Imagine there is a semiconductor company in Taiwan witnessing strong growth due to the rising global demand for chips. As an investor, you want to benefit from it and diversify your portfolio beyond the US market.
But investing directly in non-US stocks comes with many hassles. You need to follow many rules, comply with domestic and foreign regulations, manage currency volatility, and set up international brokerage accounts.
Thankfully, there is a simpler way of doing it without leaving the US markets.
Enter American Depository Receipts (ADRs), where you can invest in foreign companies while trading in US Dollars on the US stock market.
In this article, we will look at the ADR definition, cover how ADRs work, the benefits of ADRs, ADR regulation, and factors that affect ADR trading.
What is an American Depositary Receipt (ADR)?
Suppose a hit Korean drama is only available on a Korean OTT platform. Looking at its popularity, Netflix licenses it, adds subtitles, English audio, and streams it globally.
In the same way, American Depositary Receipts are like a repackaged version of foreign company shares that are traded in the US markets. Just like Netflix makes it easy for viewers to enjoy foreign content without needing to understand Korean or access the Korean platform, ADRs allow you to invest in foreign stocks using US Dollars on the US stock markets, without dealing with foreign regulations.
Investors in ADRs receive dividends in dollars, too, making the process simpler and familiar. Top traded global stocks ADR in the market include Taiwan Semiconductor Manufacturing Co Ltd., Alibaba Group, Toyota Motor Corp, Novartis AG, HSBC Holdings Plc, etc.
How Do ADRs Work?
The workings of ADRs are similar to those of equity stocks, but the issuance process is different.
There are four parties involved in the issuance of ADRs and making them available to the US investors:
Issuer Company: It must be a non-US company whose shares are being offered as ADRs. The company must agree to allow its shares to be traded in the US market and comply with regulatory requirements.
US Depository Bank: This is the American bank that issues ADRs. Its role is to buy the foreign company’s shares, hold them, and then issue corresponding ADRs in the US market.
Custodian Bank: This bank is located in the home country of the issuer company. Its role is to hold the actual shares on behalf of the US depository bank. The role of custodians is important as they ensure that each ADR corresponds to the correct number of underlying shares.
Investors: These are investors or institutions in the US that buy or sell the ADRs on the US stock exchanges. These investors can trade ADRs like common domestic stocks and receive dividends. However, voting rights are limited.
Types of American Depository Receipts
There are two major ADR types, sponsored and non-sponsored. These categories determine the level of involvement of foreign companies and how they are issued and trade in the market.
Sponsored ADRs are created in partnership with the foreign companies. The company works with the US Depository Bank, complying with ADR regulations and meeting other procedural requirements for the issue of ADRs. They are listed on major US stock markets or ADR exchanges, including the NYSE and NASDAQ.
Non-sponsored ADRs are created by brokers/dealers without involving the foreign company. These ADRs are not listed on the US stock market and are usually traded over the counter. There is less transparency, information, and support for these ADRs.
Benefits of Investing in ADRs
There are many benefits of investing in ADRs:
Convenience: It allows investors to invest and trade in foreign companies using their existing brokerage accounts. Additionally, you need not worry about complying with the complex regulatory requirements of foreign countries.
Diversification: Investing in ADRs helps diversify investments and reduce geographical concentration. You get exposure to emerging markets, global trends, and different sectors.
High Liquidity: Sponsored ADRs are traded on major exchanges, meaning you can buy and sell them quickly with minimal spreads.
Regulated and Transparent: It’s difficult to check the transparency of companies listed on foreign stock exchanges. All sponsored ADRs meet regulatory and reporting standards. This means you get access to audited financial reports and disclosures similar to US companies. It reduces the risk of poor information and improves investor protection.
ADR Risks and Considerations
Investing in ADRs entails certain risks and considerations:
Exchange Rate Fluctuation: ADR tracks the value of its underlying common stock traded in the home country. Volatility in currency in the issuing company’s country can impact the value of ADRs.
For example, if an Indian company reports strong numbers with good growth guidance, but INR falls sharply, then the value of the ADR price in USD might not rise as much or could even decline.
Political and Economic Risk: Events in the home country, like sudden regulatory changes or an economic crisis, can affect a company’s performance and investor confidence.
Voting Rights are Limited: ADR holders do not have the same voting rights as shareholders who own common stocks. Because voting rights for ADR holders require a special procedure through a depository bank.
Expense Charges: ADRs are subject to a periodic service fee intended to compensate the depository bank and custodians. The charges can generally run $0.01 to $0.05 per ADR and is usually adjusted from the dividend payments. In the absence of dividends, a different process is followed to recover the expense charges.
Taxation: Capital gains arising from the sale of ADRs and dividends received are subject to taxation per US rules and regulations.
ADR Trading and Markets
ADRs are designed to simplify investing in foreign companies. They trade just like regular U.S stocks, and major ADR markets are on the NYSE and NASDAQ.
The price of ADR is linked to the price of underlying foreign shares, and prices are maintained through a ratio called the ADR-to-share ratio.
This ratio shows how many foreign shares represent one ADR. For example, if the ADR-to-share ratio is 2:1, then it indicates that 1 ADR is equal to 2 foreign shares. This helps to align the price of ADRs with the underlying foreign stock.
After Hours and Pre-Market Trading
All ADRs are traded as per the trading hours of the US stock exchanges. However, major price movements can occur overnight, when the home country’s stock market opens.
Conclusion
Investing in foreign stocks via ADR is a simple and effective way to diversify investments and tap global growth opportunities.
But, like any other investments, ADRs come with some risks, like currency fluctuations, limited voting rights, and other economic risks in the issuing company’s country.
Still, for many investors, the long-term benefits of global diversification far outweigh the risks of investing in ADRs. With ADRs, you explore the world’s markets- one share at a time.
