- An American Depositary Receipt is issued by a bank and represents shares in a foreign company.
- US investors use ADRs to invest in overseas companies, circumventing foreign market complexities.
- There are in excess of 2,000 ADRs representing companies located in more than 70 countries.
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Let’s say you heard that Adidas is creating a network for 50,000 college athletes to be paid endorsers for its brand, and want to buy shares of the company because of the potential that brings for profits. Then you discover that Adidas stock is traded in Frankfurt, and you’re in the US.
Enter American depositary receipts, more commonly known as ADRs. An ADR is the mechanism through which you can take an international security and turn it into an American one, traded on major US exchanges. In other words, ADRs will allow you to buy Adidas, just like any other US-traded stock.
“It acts, if you will, as a wrapper around an underlying foreign equity,” says Jason Paltrowitz, executive vice president of corporate services at OTC Markets Group, which facilitates trading in US and global securities, including ADRs. “You create a receipt, or a wrapper, which turns it into a US dollar-denominated security that trades and settles in the US.”
How do ADRs work?
The first ADR was issued in 1927 to allow American investors to invest in a British department store, according to the Securities and Exchange Commis ion. There are in excess of 2,000 ADRs trading on US exchanges, representing companies located in more than 70 countries.
An ADR is a negotiable certificate that represents ownership of American Depositary Shares, which themselves represent an interest in shares of a non-US company that have been deposited in a US bank. Think of it as you would a stock certificate, which represents shares of stock. The ADRs trade in dollars and clear through US settlement systems. That permits holders to avoid the need to deal foreign currencies and the complexities of doing business abroad.
The ratio of foreign shares to one ADR varies depending on the company. For example, one ADR of the Chinese online retailer Alibaba is equal to one underlying share of Alibaba, while one Toyota ADR represents 10 of the Japanese automaker’s underlying shares. Some ADRs may even represent a fraction of one of the company’s shares. The use of such ratios allows the ADRs to be priced at an amount more suitable to US market prices.
ADRs are issued by a bank when the non-US company, or an investor holding shares of the foreign company, delivers them to the bank or the bank’s custodian in the foreign company’s home country. Having possession of the shares allows the bank to turn around and issue the ADR to American investors. The ADRs are then traded on major exchanges like the New York Stock Exchange and Nasdaq, or they can be sold over-the-counter.
Over the past decade, there has been less of a need for ADRs in more developed markets as the cost and complexity of international securities transactions declined. However, developing nations such as India and Brazil still see plenty of demand from institutional investors seeking to use ADRs to avoid the complications of local markets.
Different types of American depositary receipt programs
ADRs can be classified as “sponsored” or “unsponsored.”
Sponsored ADRs are issued with the cooperation of the foreign company. The overseas company will work directly with the US bank to arrange for record keeping, forwarding of shareholder communications, payment of dividends, and other services, according to the SEC.
An unsponsored ADR is one that is set up without the assistance of the foreign company, as may be the case when a broker-dealer who wishes to establish a US trading market issues an ADR. Most ADRs are unsponsored, according to Paltrowitz.
While an ADR can be issued without the cooperation of a foreign company, one can’t be created unless the non-US company is subject to or specifically exempted from the reporting requirements established by the Securities Exchange Act of 1934.
In addition to their classification as sponsored and unsponsored, ADRs are also categorized by the extent to which the underlying foreign company has access to the US markets. The levels differ based on their listing exposure and reporting requirements.
- Level I ADRs can only be traded on the OTC market and capital can’t be raised for the foreign company. As the only type of ADR that can be unsponsored, reporting requirements are minimal and information on the issuer would only be available on its website.
- Level II ADRs can be listed on a US exchange, but may not be used to raise capital. The underlying company is required to register and file annual reports with the SEC.
- Level III ADRs can be listed on a US exchange and be used to raise capital for the foreign issuer. The reporting requirements are similar to those US companies adhere to and thus this level represents the bulk of prominent foreign companies.
About 70% of ADRs are level 1 ADRs, according to Paltrowitz. It’s the best deal for the company because the rules basically exempt you from SEC registration, Sarbanes-Oxley compliance and more. As an example, the French food company Danone used to be listed on the New York Stock Exchange, but when the Sarbanes-Oxley Act was passed, they delisted.
“It was their view that French disclosure was just as good if not better than US. disclosure,” Paltrowitz said. “And the reality is there’s now this connectivity which you know the world is becoming smaller and they didn’t want to take on the added cost, the added risk and the duplicative reporting requirements of two regulators.”
Fees associated with ADRs
As with any investment, there are costs associated with investing in ADRs. There are the fees charged by the depositary bank, typically referred to as a custody fee. The custody fee usually covers the cost to the depositary bank for holding the non-US shares, registration, compliance and other recordkeeping services. These fees, which typically amount to between 1 and 3 cents per share can sometimes be paid through a withholding on dividends in which the depositary bank subtracts the fees from the gross dividends paid by the bank to ADR holders.
Your brokerage firm may also charge fees on top the bank that holds the ADRs, according to Holmes Osborne, principal at Osborne Global Investors, a firm.
Dividends paid by ADRs are also sometimes subject to double taxation, but the Internal Revenue Service has a foreign tax credit that US taxpayers can use to offset any taxes paid to a foreign government. Additionally, any investment gains from ADRs would be subject totaxes.
Pros and cons of American depositary receipts
As our Toyota example shows, the biggest benefit of investing in ADRs is the ease with which investors can invest in foreign companies. Some of the biggest names in business are foreign entities, and ADRs allow American investors to look overseas for new and different investment opportunities.
That said, the very nature of ADRs also introduces certain risks. Since the ADRs represent foreign investments, you’re inherently going to be exposed to currency exchange rate risks that may affect the value of your underlying investment. Aside from the exchange rate issues, there are also the political and inflationary risks of the foreign country to consider.
When and how to invest in ADRs
ADRs are your gateway to the world, without the headache of setting yourself up to actually do the work of buying on foreign exchanges. While there may be higher costs involved, if you avoid ADRs, you’ll be avoiding companies like Nestle, the biggest food company in the world, Holmes points out.
“It is the only way to invest in some of the best companies in the world – Diageo, Heineken, Volkswagen, Toyota,” Holmes says. “The list goes on and on.”
ADRs can also help American diversify their portfolios.
“This really makes sense as there are only 350 million Americans versus 7 billion people worldwide,” says Christine Armstrong, an executive director in wealth management and financial advisor at Morgan Stanley Wealth Management. “When you do the math, America may be the economic powerhouse, but we are a much smaller piece of the pie. There are many benefits to looking outside of the United States.”
If you want to get involved, doing so is as simple as buying a stock through your brokerage account. Just make sure to carefully research the ADR before you buy to make sure it fits with your investment goals and risk tolerance. If in doubt consult with an investment professional.