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American depositary receipts (ADRs) can be a way to gain exposure to foreign stocks while still trading on the U.S. stock market. In other words, investors can own foreign stocks without having to invest directly in foreign stock markets.
Here you can read how ADRs work, the different types of ADRs and the pros and cons for investors.
How do American certificates work?
ADRs are documents issued by U.S. banks that allow U.S. investors to own foreign stocks. They trade on US stock markets, such as the New York Stock Exchange (NYSE) or Nasdaq, and are valued in US dollars. The first ADR debuted in 1927 for Selfridges, a British clothing company, and was originally created by JPMorgan Chase’s predecessor company.
A custodian issues ADRs when the underlying shares are deposited with a foreign custodian. ADRs may represent a fraction or more shares or a whole portion of a foreign security.
ADRs simplify foreign investments for U.S. investors by eliminating the need to navigate foreign stock markets and transact in foreign currencies. The depository bank handles storage, currency conversion and local tax issues for ADR holders.
Example of investing in ADRs
Suppose you want to invest in Petrobras, a Brazilian energy company, but you’re concerned about the added complexity of investing in foreign companies. You can invest in Petrobras ADRs, which are shares issued by a US bank (in this case JPMorgan Chase Bank) that trade on the NYSE under PBR and PBRA.
Two more examples of foreign companies issuing ADRs in the US are Vodafone and Alibaba, but there are thousands to choose from.
“Although they may be classified as ADRs, foreign publicly traded companies can trade on a U.S. exchange just like real companies,” says James Royal, chief investing writer at Bankrate. “An ADR typically offers U.S. investors more liquidity and means investors don’t have to buy the shares on a foreign exchange, with the higher costs and other problems that can entail.”
Types of American certificates
ADRs can be divided into sponsored and non-sponsored ADRs.
Sponsored ADRs
When a foreign company goes public in the U.S. market, it often creates ADRs to help financial institutions and other interests access its offerings. If the non-US company enters into an agreement with a US bank for ADRs, it is “sponsored” by that bank. The sponsor bank takes care of the administration, paperwork and dividend payments.
Non-Sponsored ADRs
Unsponsored ADRs, on the other hand, are created without the cooperation of the foreign company and may not meet Securities and Exchange Commission (SEC) requirements.
In addition, side effects are classified into three levels.
Level I
Level I ADRs are traded over-the-counter and cannot be listed on an exchange or used to raise capital for the non-US company. Level I ADRs are also not required to provide ongoing financial disclosure reports to investors. The company may choose to voluntarily provide its annual report or other information, but you will not find disclosures and other information on the SEC’s website. Side effects at this level can be the riskiest and most speculative. This is also the only level at which ADRs cannot be sponsored.
Level II
Unlike Level I, Level II ADRs can be listed on a U.S. stock exchange, but like Level I, the ADRs cannot be used to raise capital. Level II ADRs are sponsored and have more regulatory requirements, including registering with the SEC and publishing annual financial reports. However, Level II adverse reactions are still exempt from certain reporting requirements.
Level III
Level III ADRs have the most stringent regulations and filing requirements, with SEC reporting comparable to that of domestically traded companies. At this level, the issuing foreign company may be listed on a U.S. stock exchange and raise capital.
ADR benefits
Here are some benefits of investing in ADRs:
- Easy access to foreign markets
- An ADR provides exposure to foreign equities through US brokers and is denominated in US dollars.
- Easier trading and tracking
- ADR trading is handled through US settlement systems. This means that ADRs are easy to trade and track, eliminating foreign taxes, currency conversions and direct communications with foreign companies.
- Portfolio diversification
- Investors can diversify their portfolios with international stocks using ADRs.
- Lower minimums
- Investors may be able to buy shares of some foreign companies trading as ADRs with lower minimum fees than they could if the shares were traded abroad.
ADR disadvantages
Although there are some advantages, ADRs also come with some disadvantages. Here are a few:
- Risk of double taxation
- The foreign company may withhold taxes on dividends, which can lead to potential complications in claiming tax credits.
- Limited availability
- Many popular foreign companies do not offer ADRs, so investors looking to own these stocks must go through an extra layer of complexity.
- Exchange rate risk
- The foreign country’s currency could weaken against the US dollar.
- Potential costs
- ADRs generally have custody fees, which vary and should be disclosed in the ADR’s prospectus.
In short
ADRs can provide cost-effective and secure ways to invest in foreign companies, offering several benefits, including cheap access to foreign markets and simplified taxation. Depending on the ADR, they can be sponsored or unsponsored, and each has different benefits. Ultimately, ADRs can be an attractive option for investors looking to diversify their portfolios.
