An American depositary receipt (ADR) is a security that represents indirect ownership of shares of a foreign company that isn't directly traded on U.S. exchanges. American banks purchase the shares through their foreign branches. Then, they make them available to investors in the U.S.
ADRs are one of the most important items in an international investor's tool kit. When you buy an ADR, you technically don't own the foreign stock directly. Instead, you own a piece of paper that entitles you to one or more shares of a foreign stock being held on your behalf at a depositary bank.
Learn more about how this process works, along with the pros and cons of ADRs.
What Are American Depositary Receipts?
Not all foreign companies trade directly on U.S. exchanges. But with American depositary receipts, investors can still own shares of many of these companies. Banks and other financial institutions can purchase shares of foreign companies through their foreign branches. Then, they sell ADRs in the U.S. as a form of indirect ownership. These ADRs entitle the purchaser to the foreign stock they represent, even though the bank still has title to the underlying stock.
The first ADR was created in 1927 by J.P. Morgan. This was to allow Americans to invest in shares of a British department store. Today, there are more than 2,000 ADRs available, representing shares of companies located in more than 70 countries. The Bank of New York, JPMorgan Chase, Deutsche Bank, and Citigroup are among the leading depositary banks, which create and issue ADRs.
The popularity of ADRs has surged over the years. They have a number of distinct advantages that appeal to both small investors and professional money managers alike.
A single ADR may represent one share of a foreign company, or it may be a fraction of a share. It depends on the company and the foreign exchange rate involved. This enables firms to convert prices to amounts more appropriate for American exchanges.
How ADRs Work
Let's say you're interested in investing in France. One option is to open a brokerage account in Paris, wire some money over there, convert your dollars into euros, and then go shopping for French stocks. This would be a difficult and time-consuming process. Also, your accountant would not be very happy with you at tax time.
ADRs can eliminate these hassles. You won't have to deal with currency conversions and opening foreign accounts. Instead, you can buy ADRs of French companies that banks and brokers make available on the American exchanges or over the counter.
Advantages and Disadvantages of ADRs
Easy to use
Available through your U.S. broker
Trade on U.S. market hours
Limited selection of securities
Exchange rate fluctuations
Difficult to diversify
American Depositary Receipts have a number of benefits that make them an ideal opportunity for international investing, including:
- Ease of use: ADRs can be bought and sold just like shares of IBM or Google.
- Same broker: You don't need a foreign brokerage account or a new broker; you can use the same broker that you normally deal with.
- Dollar-based pricing: Prices for ADRs are quoted in U.S. dollars. And dividends are paid in dollars.
- Standard market hours: ADRs trade during U.S. market hours; they are subject to similar clearing and settlement procedures as American stocks.
By the same token, ADRs have some important limitations and drawbacks. These include:
- Limited selection: Not all foreign companies are available as ADRs.
- Liquidity: Plenty of companies have ADR programs available, but some may be very thinly traded.
- Exchange rate risk: While ADRs are priced in dollars, for sake of convenience, your investment is still exposed to fluctuations in the value of foreign currencies.
- ADRs are like stocks: You need to buy enough of them to have enough diversification. So if you don't have enough investment capital to spread around, say 25 to 30 ADRs (or more), you won't be able to create a truly diversified portfolio on your own.
- Higher fees: ADRs can carry higher fees than traditional stocks.
There are three levels of ADR programs: Level 1 ADRs, available over the counter, are the most risky. Level 2 and 3 ADRs are progressively less risky. That's because the Securities and Exchange Commission puts stricter reporting requirements on them.
ADRs have a number of unique differences relative to foreign stocks or traditional U.S. stocks that are equally important to consider.
For instance, there is a significant difference in the way that taxes are charged on dividends. As with U.S. stocks, dividends are taxable in the U.S.
Unlike U.S. stocks, the dividends may also be subject to tax by the company's home country. However, they're usually automatically withheld by the sponsor. Investors may choose to apply a credit to their U.S. taxes or apply for a refund abroad to avoid double taxation.
Before investing in ADRs, you may want to consult with a financial advisor and a tax advisor to understand the implications for your portfolio.
When to Use ADRs
Once you have a bit of international investing experience under your belt, ADRs can be a powerful tool to customize your portfolio or make targeted investments in specific companies, sectors, and countries. The flexibility may be especially appealing to value investors looking to expand their reach into international markets rather than only being able to access domestic stocks.
If you are just getting started in international investing, though, it's much easier to stick with a good international mutual fund or ETF until you have a firm grasp of the basics.
- American depositary receipts (ADRs) represent indirect shares in foreign companies.
- U.S. financial institutions purchase shares through their foreign branches and make them available to American investors.
- ADRs offer a simple way for many investors to purchase foreign stock without dealing with foreign banks and exchange rates.
- However, they are typically more expensive and challenging than investing in international funds.