What is an American Depositary Receipt (ADR)?

An American Depositary Receipt. or ADR. references the trading shares of a foreign entity on a US stock exchange. They provide easy access to gaining international equities exposure without actually having to exchange currencies and open additional accounts to transact in overseas. They also avoid foreign taxes on each transaction and reduce the admin fees associated to maintaining an overseas account.

ADRs will trade like any other stock and are dollar denominated securities, meaning they are traded in dollars and they pay their dividends in dollars as well. American depositary receipts are essentially sponsored or issued by US banks. They buy up shares of the foreign stock and repackage them into securities which can be traded on the NYSE, Nasdaq or AMEX. Each depositary receipt represents a specified number of shares in the foreign stock; it does not have to be 1 to 1 as many believe. Therefore, if a US bank buys an Indian internet stock for the equivalent of $3 and then turns around and issues the stock in the US at a 5:1 ratio, the Indian ADR would be released into the market at $15. Once the security enters into the marketplace, forces of supply and demand take over.

Types of ADR’s

There are three main types of ADR issuances. They are classified as Level 1, Level 2, and Level 3.

Level 1 ADRs are the most common and most basic depositary receipts. They are traded on the over the counter (OTC) market and have the least amount of regulatory requirements as stipulated by the SEC. These companies do not have to abide by US accounting standards, nor do they have to issue annual reports.

Level 2 ADRs can be listed on the stock exchanges that we discussed above and have more regulatory requirements, they will be required to file a form 20-F and also register with the SEC. They will naturally have much higher trading volumes than level 1 ADRs due to their exposure to the NYSE and Nasdaq markets.

Level 3 ADRs is the most respected level a foreign company can achieve in the US markets. These companies are put under a microscope and often have more regulatory scrutiny on them than US stocks themselves. They are able to go as far as raising capital from US investors and have a large footprint in the US markets.

Disadvantages of ADRs

There are some disadvantages and risks to trading ADRs. For one, there is a very small selection of ADRs available for trading and they do not generate the type of interest that typical US equities do. This means they are traded thinly and have larger bid/ask spreads.

These are some obvious drawbacks but there are a few other risks that you would not normally consider if you purchased US equities.

For one, there is always country specific risk. For example, there are a few gold mines in South Africa which tends to have instability within their government. Even though the price of gold may go through the roof, these mines may not generate enough money for their shareholders depending on the policies of their government.

Forex rates can errode your returns if the home currency of the ADR starts to devalue significantly against the US dollar. Extending this topic out a bit; inflationary pressures can also hurt the bottom line of the foreign company.

Finally, if your purpose was to diversify your porfolio to include overseas companies, you may not be doing a great job of it by holding on 2 or 3 ADRs. International mutual funds will do a much better job of diversification for those of you who do not have enough funds to split over 15 or 20 ADRs.

It is extremely important that investors understand the risks associated with the political and economic climate in the home country of their ADR.