ADRs! That’s a fun acronym, but what are they? You may not even know what ADRs are, or why they matter, or what they do, and that’s totally fine. They occupy a small space in the world of finance, but might be responsible for a lot of ownership in your portfolio. ADR stands for American Depository Receipt, again, not much more revealing than the acronym. An ADR is a certificate that proves for ownership of a basket of foreign stocks. Usually, the way it works is a large bank will buy a bundle of shares of some foreign domiciled company like Samsung, T-Mobile, Volkswagen, etc, and then resell the right to those shares to you. Once they buy that bundle of shares, they’ll create their own shares (ADRs) that represent ownership in that bundle of foreign shares. These ADRs are traded during the U.S. session and are named for the companies that they represent. When a U.S. bank is the intermediary in this flotation of shares, that’s called sponsorship.
So how did all of this come about? Well like the light bulb and the airplane, necessity and profit is the mother of invention. Back in the 20’s it was becoming incredibly complicated for individual investors to purchase shares in foreign countries, so in 1929 banks decided they could repackage these foreign shares and make it easy for the U.S. investors. Americans bought the shares, and banks made money on flotation costs. The banks sometimes change the ratios between the number of foreign shares that the ADR represents to keep the share price between $10 and $100 a share. This is typically the price range when stock splits occur (ETFs don’t count because they are funds). For instance, if you had a Mexican stock for 50 pesos, that would represent $2.30 (as of January 12th, looking at you Trump) and big institutional investors don’t usually like to buy shares with a share price less than $5.
There are three types of ADR issues, level 1, level 2, and you guessed it, level 3. The higher the level, the more legitimate and qualified the ADR is. Level 1 is generally OTC. These are companies that may not have even wanted to be on the NYSE or AMEX because level 1 ADRs don’t usually qualify to be on U.S. exchanges. They have the loosest requirements to be listed by the SEC, and these shares are often referred to as “pink sheets”. Level 2 is the next step up, and can be listed on an exchange. They may also be quoted on Nasdaq. With greater power comes greater responsibility though, as the SEC requirements are a little more in-depth for these guys. Level 2 usually gets higher visibility, and with that, trading volume. This might be valuable to the company floating the shares, and is likely to be valuable to the investors. Level 3 is the gold standard. This is where an issuing bank will actually purchase the shares and sponsor the ADR. This gets the highest volume trading and has even more SEC requirements. Fun!
So you may be wondering about the advantages and disadvantages are that you should be aware of here. Well, there are a few. Some pros are that ADRs are an easy and cost-effective way to purchase shares in a company that is domiciled outside of the United States. You don’t have to pay an expense ratio for an emerging markets ETF or foreign stock mutual fund if you can purchase the shares directly. It also gives foreign companies exposure in the U.S. which can be very helpful to get a valuation of a foreign company in sweet sweet United States dollars. Some stock markets (such as China) aren’t always tied to earnings, so it’s useful to set a company market capitalization to earnings using the U.S. stock market, and then let foreign markets trade off of the U.S. price. Most of these ADRs are margin-able and have adequate liquidity for portfolios too. Taxes get a little messy though. For instance, imagine if you get paid a dividend on those shares. That dividend will be paid in a foreign currency, sent to the bank, converted, and then dispersed to you. You may have to pay withholding on that income. Sometimes the tax alone can completely wipe out the benefit of the foreign dividend. Here’s a list of withholding rates by country if you’re into that kind of thing.
Now, an interesting situation arises. One asset is floating around in two markets. Is it possible to find a price disparity? Well in fact it is! There are three possible explanations for why this price disparity may occur. Sometimes there is a liquidity premium or discount placed on the ADR shares because they are being traded in the U.S. market which is usually more liquid. Most of the time the lower liquidity market should catch up to the higher liquidity one. Another cause of ADR price disparity is a restriction on the number of shares that can be owned by foreigners. If there’s a law that limits the number of shares to a specific market; well put that through a supply and demand context and go from there. Short squeeze galore. Investors may also view certain markets as being less risky than others. For instance, if there are numerous transaction fees in one country, or it’s much easier to transfer assets in another country, that country will be perceived as less risky, and a premium will be assigned to that asset. Just to be clear though, it’s a pretty tall order for individual investors to profit from a price disparity. That’s because it’s hard to purchase shares in a foreign market when you don’t live there, and like most arbitrage opportunities, the big guys are usually onto it before you are.
Another fun fact, this explains what the SA/NV letters mean that you might see after some ticker symbols. It’s the foreign country’s version of incorporation or whatever legal structure those companies assume. Hopefully this helped in understanding a little more about foreign assets and how the market interacts with them. Not quite as exciting as opening a foreign bank account to launder money, but it’s worth knowing!