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An American Depository Receipt (ADR) is a type of investment security that allows investors in the United States to buy shares in foreign corporations that are not usually traded on U.S. stock exchanges. As such, ADRs represent a convenient way for U.S. investors to take advantage of investment opportunities in foreign countries and receive dividend payments in dollars. However, ADRs come with intrinsic risks and costs that investors should take into account before proceeding in their purchase. Read on to find out what you need to know about investing in American Depository Receipts.

ADR Creation

The creation of ADRs involves the cooperation of the issuing corporation, a qualifying domestic bank and a domestic stock exchange. Foreign corporations may contact banks in the United States and inform them that they would like to offer a certain amount of stock on the U.S. market through the issuance of ADRs. Domestic banks then purchase this stock from the issuer and make listings of the ADRs on U.S. stock exchanges, with each ADR representing a certain amount of stock. Foreign corporations that do this are generally reputable entities that already have their stock listed in foreign exchanges. Such companies can list their stocks on U.S. exchanges without going through an ADR deal, but issuing through ADR allows them to quickly sell a bulk amount of stock at a set price without worrying about many of the legal and technical issues associated with listing stock in the United States.

Benefits For Investors

Normally, when an investor wants to put cash toward a company listed on a foreign stock exchange, this means a lot of additional effort and expense. Your broker may not normally offer services for stocks traded abroad. If investment in foreign stock is allowed, it may result in extra brokerage fees. On top of that, when you receive dividend payments or sell your stock later, you will probably have to deal with additional fees related to the conversion of foreign currency into dollars. However, by investing in ADRs, investors in the United States can limit trouble and costs by dealing entirely with a domestic entity and receiving dividend payment directly in domestic currency.

Some might ask why they should even consider investment into foreign markets when they can already invest in the world’s largest market. However, while U.S. stock exchanges do offer a wider selection than those of any other country, the economy of the United States is simply not growing as quickly as the economies of other nations and this is reflected in stock value growth. ADRs can help U.S. investors to put their money toward high-performance stocks in emerging markets like the BRICS (Brazil, Russia, India, China, South Africa) and MIKT (Mexico, Indonesia, Korea, Turkey) economies, among others. In addition to higher growth rates, U.S. investors also like to use ADRs to invest in these economies for the sake of diversification. (For more information on portfolio diversification, see Understanding How To Diversify Your Investment Portfolio .)

The Risks Of Investing In ADRs

Despite the many advantages of ADR investments, there are some disadvantages as well. These can be seen most prominently in three specific types of risk:

• Political Risk. Nations around the world have varying levels of political stability. For instance, even if a particular nation has consistently exhibited high levels of growth for several years, investing in companies located in that nation may still be risky if there is any chance of civil unrest, revolutions, sudden tax hikes or seizure of private assets by the government.
• Exchange Rate Risk. Even though investing in ADRs allows you to easily receive payment in dollars, this does not mean that the pitfalls of cross-currency investment have all been removed. Dividends and stock values are still denominated in the currency of the host country. If sudden changes in exchange rates occur, this can lead to losses even when dividends and stock values increase relative to the denominating currency.
• Inflationary Risk. Inflationary risk is similar to exchange rate risk in that it deals with the investment risks related to changes in currency values. However, while exchange rate risk is a matter of short-term volatility in exchange rates, inflationary risk is a matter of long-term trends toward inflation. For instance, if the denominating currency is manifesting 2 percent inflation on average, this speaks well of stock values tied to that currency. However, if the denominating currency follows a trend of 15 percent average inflation per year, this can constitute a significant burden on investors, causing them to lose wealth even when their investments gain nominal value in the host currency.

Because of these risks, before investing in ADRs, U.S. investors should research the political history and circumstances of the host nation as well as its recent trends of currency values.

Taxation

Aside from the added risks that ADR investors face, they also face some other disadvantages. One of these is the matter of taxation. Capital gains and dividends earned from ADRs are typically taxed in the same manner as capital gains and dividends from normal domestic investments. However, host countries often levy their own taxes on dividends paid to foreign investors. For this reason, ADR investors must make sure to claim deductions from foreign taxes paid. Otherwise, they may end up getting double-taxed.

Finding ADRs

To find ADRs in which you can invest, consult your stock broker or a deposit bank that specializes in ADRs. Some examples of banking institutions that issue ADRs are BNY Mellon, Deutsche Bank and J.P. Morgan.

If you want to invest in foreign stock without the headache of dealing with foreign stock exchanges, ADRs might be a good investment for you. However, as with all investments, ADRs are not risk free. Make sure you do your homework before putting your money into ADRs.