Over the last one year, the primary indicator of the US stock market performance, the S&P 500 index, has grown by a meager 2.5%. In comparison, during the same time, the main German stock market index, DAX, has grown by over 13%, while the primary French stock market index, CAC 40, has gained 16.5%.
The results above highlight the importance of being able to invest globally to take advantage of the markets experiencing more favourable conditions than the US market. However, direct access to foreign equity investment opportunities is complicated for many US-based investors. The optimal solution for these investors lies in using American Depositary Receipts (ADRs). In this article, we cover all the details of these financial products.
What Are the American Depositary Receipts (ADRs)?
ADRs are certificates issued by US banks that represent shares of foreign companies' stocks. They are traded on US stock exchanges and allow American investors to indirectly invest in foreign companies. ADRs are denominated in US dollars and typically represent a specific number of underlying foreign company shares.
A US bank issuing an ADR invests in a foreign stock directly at an overseas exchange. In turn, the bank issues ADRs linked to the stock locally in the US. As such, the bank might be considered an intermediary between the foreign company/stock and American investors purchasing the ADRs.
Sponsored vs Unsponsored ADRs
There are two primary types of ADRs - sponsored and unsponsored.
A sponsored ADR is one that is created through a formal agreement between the foreign company and a depositary bank. The depositary bank acts as an intermediary between the foreign company and US investors. The bank issues the ADRs, holds the underlying shares of the foreign company, and handles the administrative tasks associated with the ADR program.
The foreign company actively supports the ADR program it sponsors and often considers it an important way of accessing the US market.
Sponsored ADRs are generally considered to be the more desirable type of ADR. This is because they are subject to stricter regulatory requirements and provide more transparency to investors. The foreign company is also typically more involved in the ADR program, which can provide investors with greater confidence in the program's integrity.
Unsponsored ADRs, on the other hand, are created by third-party institutions without the involvement of the foreign company. These third-party institutions, which could be banks or brokerages, purchase shares in the foreign company and then issue ADRs that represent ownership of those shares.
The foreign company is not involved in the process and may not even be aware of it. Unsponsored ADRs are generally considered to be riskier than sponsored ADRs. This is because they are not subject to the same regulatory oversight and are often less transparent than sponsored ADRs.
Three Levels of ADRs
There are different types of ADRs, each with different reporting and compliance requirements. The three main types are:
Level 1 ADRs: These are the most basic form of ADRs and have the fewest reporting obligations. Level 1 ADRs can be traded over-the-counter but not via a US stock exchange. Level 1 ADRs are typically sponsored by companies that are not able or willing to be listed on any US stock exchange. These ADRs need to meet only the lowest reporting requirements from the SEC. They are typically more speculative and high-risk in nature than the higher level ADRs below. Unsponsored ADRs can only be Level 1.
Level 2 ADRs: These can be traded on a US stock exchange and need to meet more stringent reporting requirements from the SEC than Level 1. Level 2 ADRs, however, cannot be used by foreign companies to raise capital via an IPO.
Level 3 ADRs: These have the most stringent reporting requirements and are typically sponsored by companies that are listed on a foreign stock exchange and want to raise capital in the US market via an IPO.
Advantages of ADRs
ADRs provide a number of benefits to both investors and foreign companies. Some of the pros of ADRs relevant to US investors include:
1. Convenient Access to Foreign Markets: ADRs provide a convenient way for US investors to access foreign markets. Investors do not need to open a foreign brokerage account or deal with foreign currency exchange rates.
2. International Diversification: Investing in ADRs can provide diversification benefits to a portfolio. ADRs allow investors to gain exposure to companies that they may not be able to invest in otherwise. Although ADRs are traded on US stock exchanges, primarily the NYSE or NASDAQ, they represent unit shares in companies that are subject to their respective foreign market dynamics.
3. Increased Liquidity: ADRs are traded on US stock exchanges and typically have higher trading volumes than shares listed on foreign exchanges. This can increase liquidity and trading flexibility for investors.
4. Regulatory Protection: Investing in ADRs can reduce the risks associated with foreign investments. ADRs are subject to US securities laws and regulations, which can provide a higher level of protection for investors. Dealing with the financial laws and regulations of foreign jurisdictions, especially if problems arise, is far from the easiest task for an investor, be it a large institutional entity or a small retail investor.
Disadvantages of ADRs
ADRs also have some disadvantages or risks that investors should be aware of, including:
1. Fees: ADRs can be subject to a bouquet of fees, including custodial fees, transaction fees, and currency conversion fees. These fees can reduce investor returns. If you plan to invest in an ADR via an American financial institution, study the fee structure carefully since it will likely be more complex than the fees involved in buying US stocks.
2. Currency Conversion Risk: ADRs are denominated in US dollars, but the underlying company’s stock at the foreign exchange is, naturally, based on that country’s currency. This exposes investors to the risk arising from fluctuations in exchange rates.
3. Political Risk: Investing in ADRs can expose investors to political risks associated with the foreign country in which the underlying company operates. Changes in government policies, regulations, or other political events can affect the company's performance and investor returns. In many countries, government regulation or political pressures may affect the stock market much more profoundly than many US investors could imagine.
4. Limited Choice: Not all foreign companies decide to get exposure to the US market via sponsored ADRs. Many lucrative overseas stocks are not accessible to US investors via the ADR route.
Despite the drawbacks, ADRs are an excellent tool for US investors to access well-performing overseas stocks and markets. Many leading non-US brands offer exposure to their stock via ADRs and for many investors, ADRs, are the optimal way to own a part of these companies without the hassle and complexities of investing directly on overseas exchanges.