Understanding American Depositary Receipts & How to Invest in Them
The US stock markets are the largest globally. When combined, they are five times the size of the closest competitor. The US stock markets are so large they account for just under half of global equity value.
Therefore, US stock exchanges are attractive venues for companies operating outside the United States who want to raise new or additional capital. The American Depositary Receipt (ADR) enables this process to take place. In this article, we will look at what ADRs are, why people invest in them and how you can start trading them.
What Are American Depositary Receipts (ADRs)?
What is an ADR? An American Depositary Receipt (ADR) certificate is issued by a US depositary bank representing a certain number of shares (usually one) of a foreign company. ADRs are traded on the US stock markets, just like other stocks.
It is essential to know that an American depositary receipt may be part of a company’s share or several shares. The use of a ratio allows ADRs to become set at a typical market price in the United States.
Let’s imagine the shares of a Chinese company, for example:
- USD/CNY = 7 (i.e. 7 Chinese Yuan to 1 US Dollar)
- The share price of the Chinese company on the local stock exchange is 1 yuan, about $ 0.14.
- ADR with a ratio of 100:1 (100 Chinese company shares for 1 ADR) trades at an approximate price of 14 dollars (100 * 0.14).
For an American depositary receipt to be issued, a company must first deposit its shares in a US bank. Once issued, the company’s ADRs are traded only in US dollars and pay their US currency dividends. In this way, US investors avoid foreign currency transactions.
Interesting ADR facts:
- J.P. Morgan introduced the first ADR in 1927 for the British retailer Selfridges on the New York Curb Exchange, the American Stock Exchange’s precursor.
- More than 2,000 American depositary receipts are traded today.
- Companies from more than 70 countries are represented on US stock markets through ADRs.
American depositary receipts are subject to cancellation at the discretion of either the foreign issuer or the depositary bank that created them.
The termination leads to the cancellation of all issued ADRs and delisting the foreign shares from the US stock exchanges where they were listed.
Before termination, the company must write to all ADR owners, allowing them to exchange their ADRs for foreign securities. If the owner decides to keep its ADRs after termination, the custodian bank will continue to hold foreign securities and collect dividends but will no longer sell ADRs.
What Is the Purpose of ADRs?
American depositary receipts allow US investors to invest in companies outside of the United States, whilst giving non-US companies ready access to US stock markets. An ADR already issued can be obtained from the NASDAQ or NYSE.
With ADRs, US investors get an additional opportunity to diversify their investment portfolios. Previously, US investors had to:
- Exchange USD into the local currency of the company in which they wanted to invest
- Open an account with a broker who offers the shares of the desired company
- Buy the foreign shares
- Monitor the price of the stock in a different time zone
- When they close their position in the foreign stock, exchange their currency back into USD
By using ADRs, US investors can buy shares in companies - such as Alibaba, Sony and Royal Dutch Shell - without going through the steps listed above. Investors get exposure to companies of their choice while their transaction is denominated in US dollars.
What Are the Different Types of ADRs?
American depositary receipts are of two main types:
- Sponsored ADR
- The bank issues a sponsored ADR on behalf of a foreign company. The bank and the company enter into a legal agreement. The foreign company usually pays the costs for issuing the ADR and maintaining control over it and the bank will handle the investor transactions. Sponsored ADRs are categorised according to how the foreign company complies with the Securities and Exchange Commission (SEC) provisions and US accounting procedures.
- Unsponsored ADR
- A bank may issue an unsponsored ADR without the direct participation or permission of the foreign company. Theoretically, there can be several unsponsored ADRs for the same foreign company issued by various US banks, while in a sponsored ADR, there can be only one. These multiple offers can also offer multiple dividends.
One of the critical differences between the two types of American depositary receipts is where investors purchase them. All but the lowest level of sponsored ADRs are registered with the SEC and traded on major US stock exchanges.
Simultaneously, unsponsored ADRs can only be traded on Over-The-Counter (OTC) markets and do not include voting rights.
ADRs are categorised into three levels, depending on how the foreign company gains access to US stock markets.
- Level 1 - This is the primary type of ADR, in which foreign companies do not meet the requirements or do not want to become listed on the stock exchange. This type of ADR can be used to establish a commercial presence but not to raise capital. Level 1 ADRs can only be traded in OTC markets and have the most stringent SEC requirements. Although more volatile than other ADR levels, they are an easier way for a foreign company to assess US investor interest levels in its shares. Only this level of ADR can be unsponsored.
- Level 2 - Like Level 1, Level 2 ADRs cannot be traded on a stock exchange and cannot be used to raise capital. However, they have slightly more requirements from the SEC, more transparency and greater trading volume.
- Level 3 - These are the most prestigious American depositary receipts. The issuer publicly launches ADRs on the US stock market. Level 3 ADRs can establish a significant commercial presence in US financial markets and raise capital for a foreign issuer. Issuers are subject to full reporting to the SEC.
Why not test out trading strategies, with some of the most popular ADRs, without risking your capital on a risk-free demo trading account from Admirals? Sign up for your demo account by clicking on the banner below:
Why Invest in American Depositary Receipts?
Investors make their investment decisions for various reasons, such as building a long-term capital base, paying for a child’s education, generating capital for their ventures, planning retirement, achieving financial goals or merely increasing their disposable income.
Since most ADRs get traded like stocks, the reasons that may lead you to invest in American depositary receipts include:
- An alternative to holding cash in the bank, which currently returns close to zero in interest.
- ADRs can act as protection against inflation.
- ADRs offer opportunities for capital gains and the achievement of financial goals.
- ADRs provide diversification of portfolio assets.
- By way of dividends, ADRs can help to build passive income.
- High levels of liquidity; you can buy and sell ADR assets in seconds.
- Due to the liquidity, you can take advantage of low spreads and commissions
- Low initial investments (the Invest.MT5 from Admirals has a minimum deposit of just €1)
Although investors may have other reasons to invest in American depositary receipts; some of the most rational are listed above.
Risks of Investing in ADRs
Similar to other investments, ADRs have specific risks and disadvantages, for example:
- Some ADRs have low liquidity
- In some instances, ADRs can lead to higher taxes than investing in shares.
Not all companies outside the United States have ADRs and in the next part of the article, we will highlight some of the largest companies which do.
Most Popular American Depositary Receipts
There are more than 2,000 ADRs traded, over 400 of which are Level 3 ADRs and traded on US stock exchanges. They are the most prominent companies and are among the most bought and sold.
Let’s have a look at an American Depositary Receipt list of shares available to trade via Admirals.
With Admirals, you can invest in hundreds of the most popular American depositary receipts from China, Japan, Australia, Great Britain, Germany and many other countries around the world.
How to Start Investing in ADRs
Now you understand the concept of ADRs, the various types and why people invest in them - it’s time to move on to the more exciting part; how to start investing American depositary receipts.
In order to get started, you need to follow these three steps:
- Open a trading or investing live or demo account.
- Click on Trade next to your account open the web platform.
- Search for your stock or ADR to see a full list of ADR stocks in the search window.
- Click New Order to open the trading ticket to input your trade levels.
With Admirals, you can start trading ADRs and thousands of other financial instruments with the world’s number 1 multi-asset trading platform - MetaTrader 5.
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FAQs on American Depositary Receipts
What are differences between ADR and GDR?
An ADR is an American Depositary Receipt which represents shares of a single foreign company that have been issued in the U.S. A GDR is a Global Depositary Receipt which represents shares of a single foreign company that have been issued in more than one country.
What are the risks of depositary receipts?
On top of the usual risks of investing such as winning and losing, some depositary receipts may have low liquidity making it difficult to buy and sell a company. Foreign laws can also change very quickly causing sharp sudden moves in its share price listed in other countries.
Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.