Shutterstock

ADR stock can be a valuable addition to any investor's portfolio, but it is important to understand how to invest in them intelligently. Discover what an ADR stock is, the different kinds of ADR stocks you can invest in, the advantages and risks associated with each ADR, and more.

What Is an ADR Stock?

American Depository Receipts (ADRs) are registered foreign stocks that are traded on American stock exchanges like any other domestic, publicly-traded company. Sometimes ADR stocks are also called American Depository Shares (ADSs).

ADRs are listed on the New York Stock Exchange, American Stock Exchange, and Nasdaq. They can also be purchased over the counter, depending on the type of ADR stock being purchased.

The ADR itself is a certificate issued by a domestic depository bank that details the number of shares held in foreign stock. They are quantified in U.S. dollars.

ADR stocks were originally created in the 1920s to make investing in foreign stock easier. Before ADRs were created, investors would need to purchase an internationally-traded company on a foreign stock exchange, which was inaccessible for many people. To make sound investments, investors also needed to have an understanding of the financial rules and regulations of the country they were purchasing from. This obviously created obstacles for many investors.

ADRs have helped bring rise to today's globalized market and have made investing in international stocks significantly easier and more secure than it had been in the past.

What Are the Types of ADR Stocks?

ADRs come in a few different forms and categories. Each presents its own advantages and risks. Here are the basic types of ADRs.

Bank-Sponsored ADR Stocks

This type of ADR stock is the result of a single deal struck between an American bank and a foreign company. This legal agreement dictates that the company will absorb the costs of issuing the ADR while retaining control over the security. This also provides the foreign company to register the ADR with the Securities and Exchange Commission (SEC), allowing the stocks to be listed on American stock exchanges.

Foreign companies benefit from this arrangement because their stock will become more enticing to major American investors. Despite ADRs being denominated in U.S. dollars, the foreign company will also still have revenue and profits defined by their nation's currency.

There are three different categories of ADR stocks:

  • Level 1: This category of ADR stock is relatively easy for foreign companies to obtain, as it does not require the high level of disclosure typically required for publicly traded companies and does not enforce particular accounting guidelines. However, this means that these ADRs cannot be listed on American stock exchanges. Investors should proceed with caution when investing in Level 1 secure ADRs due to the lack of disclosure required by the foreign company.
  • Level 2: To obtain level 2, the foreign company must comply with SEC rules and regulations. This allows the ADRs greater exposure, as they can be listed and traded on American stock exchanges.
  • Level 3: This level of sponsored ADR allows the foreign company to raise capital from U.S. investors. While this comes with many benefits, the company must strictly adhere to SEC rules and regulations and must be transparent with disclosures.

Unsponsored ADR Stock

Similar to sponsored ADR stocks, unsponsored ADR stocks are foreign stocks that have been created by a bank that holds common stock in a foreign company. However, this is done without having a legally binding agreement with the foreign company and can be issued by more than one bank.

While the value of an unsponsored ADR is similar to that of a sponsored ADR, investors in unsponsored ADRs do not have voting rights or other shareholder benefits. Additionally, these stocks cannot be traded on American Stock Exchanges and are always sold over the counter.

This can present some risk for the investor. Because unsponsored ADRs are not sanctioned by the issuing company, investors must trust their banks or brokers.

What Are the Advantages of ADR Stocks?

ADR stocks can present some great benefits for American investors, including:

  • Simplification: Purchasing ADRs simplifies the process of investing in foreign stock. The value of the stock is denominated in U.S. dollars, making understanding the value of your ADR easy. It also allows you to work with U.S. banks, brokers, and stock exchanges that American investors will already be familiar with. Additionally, for secured level II and III ADRs, investors can be assured that the foreign company is compliant with SEC rules and regulations.
  • Diversification: U.S. investors can utilize ADRs to diversify their portfolios while avoiding the complications and risks associated with direct foreign investments.
  • Lower Cost: Purchasing foreign stocks directly can be costly. Purchasing ADRs is often a more cost-effective option for investors.

What Are the Disadvantages of ADR Stocks?

While there are a number of advantages to purchasing ADR stocks, there are also some disadvantages to be aware of before you invest:

  • Exchange Rates: Like investing in any foreign market, investors must take exchange rates into account. There is always a risk that the exchange rate will not work in the investor's favor.
  • Less Selection: Many foreign companies do not have ADRs, no matter how large the company may be. Investors who narrow their foreign trading scope exclusively to ADRs may exclude other sound foreign investments from their portfolios.
  • Under-diversification: While purchasing ADRs can diversify an investor's portfolio, it can also lead to under-diversification if an investor does not purchase an adequate number of shares. This can be a risk when purchasing any kind of stock.
  • High Taxes: Tax is charged differently on ADR dividends than for other types of stock.

How Are ADR Stocks Taxed?

When investing in ADR stock, it is important to be aware of the taxation laws. ADR stock dividends are taxed differently than other kinds of stock. Dividends are first taxed like any other American stock, but depending on the type of ADR, there may be additional taxes from the company's home country that the investor is required to pay.

If the ADR stock is sponsored, it is likely that the sponsor will automatically withhold these foreign taxes. However, this is not the case for unsponsored ADRs.

To avoid getting taxed twice, some investors apply for a tax credit from the IRS or apply for a refund in the company's home country.

Before investing in ADR stocks, it's important to consider the tax implications for your portfolio.

Do ADR Stocks Pay Dividends?

Many ADR stocks do not pay regular dividends, but some do. Both sponsored and unsponsored ADRs have the potential to pay dividends.

During the dividend payout process, the issuing bank (or banks, which is often the case for unsecured ADRs) will take the dividends provided by the foreign company in their home currency and convert into U.S. dollars. The dividend will then be passed along to the American investor in U.S. dollars.

This can be a benefit or disadvantage to the investor, depending on the currency exchange rate when the dividend is issued.

Introducing TheStreet Courses: Financial titans Jim Cramer and Robert Powell are bringing their market savvy and investing strategies to you. Learn how to create tax-efficient income, avoid mistakes, reduce risk and more. With our courses, you will have the tools and knowledge needed to achieve your financial goals. Learn more about TheStreet Courses on investing and personal finance here.