If you have ever invested in Nestle, Toyota, BP or Sony, the odds are high that you didn't own the actual stocks but rather a piece of paper known as an American Depositary Receipt or ADR that stood in for the shares. What these stocks all have in common is that they are foreign companies that trade on exchanges outside the United States. ADRs give American investors access to international stocks in U.S. dollars, avoiding the complexities of trading on distant markets across disparate time zones.
While it is possible to invest directly in foreign companies on their own local stock exchanges, the process can be complicated and may involve setting up accounts on foreign exchanges and dealing with currency translations. Some U.S. brokerages offer limited direct foreign investing, but the process is not as simple as trading in U.S. markets and still involves currency conversions. ADRs allow U.S. investors to purchase shares of international stocks in U.S. dollars during U.S. market hours according to American settlement terms and provide access to two thirds of all publicly traded companies in the major global market indexes.
Until the 1920s, Americans who wished to buy foreign stocks had to set up brokerage accounts in each of the countries in which they wanted to own stocks. They also had to convert their dollars into pounds, francs, or rupees to execute their trades and then convert these foreign currencies back to dollars when they repatriated their proceeds. Obviously, this limited access by most average investors to U.S. stocks only, largely depriving them of the benefits of international diversification.
In 1927, JP Morgan predecessor Guaranty Trust created the first ADR allowing U.S. investors to purchase shares of British retailer Selfridges on the New York Curb Exchange (later known as the AMEX). Today there are over 2,000 separate ADRs tied to companies in 70 countries actively trading in the U.S.
An American Depositary Receipt is created when a large bank purchases a block of a company's native shares on its own domestic exchange and holds the shares on deposit. Referred to as a depositary bank, this institution can then issue tradeable securities that represent the shares on deposit but can be bought and sold on U.S. exchanges just like any other American stock. ADRs trade on the New York Stock Exchange, the NASDAQ, and in the over the counter or OTC market.
The depositary bank establishes a ratio of depositary shares to underlying native shares to align the ADR price in a desirable target range on the U.S. exchange. For example, Toyota ADRs were issued at a 1:2 ratio, meaning each ADR represents two ordinary Toyota shares on the Tokyo exchange, while one ADR of BP equals six shares on the London exchange. Volkswagen, on the other hand, has a ratio of 10:1, meaning that there are 10 ADRs per individual share of VW stock on the Frankfurt exchange.
American Depositary Receipts can be broadly delineated according to the participation of the company whose stock is being traded. A sponsored ADR is initiated by the company in partnership with the depositary bank to promote the distribution of its stock in the U.S. Unilever, the UK maker of Dove, Ben & Jerry's, and Hellmann's, partnered with Deutsche Bank to issue ADRs that trade on the New York Stock Exchange. Sponsored ADRs listed on the NYSE and NASDAQ must register with the SEC and publish financial statements according to U.S. accounting standards in Dollars, and in some cases can even issue new IPO shares to raise capital for the parent company.
Unsponsored ADRs are created by a depositary without any involvement or approval of the underlying company and trade in the over the counter (OTC) market. This can occur if a bank believes the issue can be profitable, or if the company participating in a sponsored issue decides not to renew a listing agreement. Volkswagen's ADRs began as a sponsored issue but the company declined to renew its listing agreement with JP Morgan in 2018 and the U.S. ADRs began trading as an unsponsored OTC issue with a different ticker symbol.
While ADRs simplify access to international stocks without worrying about currency translations, they do not shield the investor from exchange rate risk. This is a common misconception. On the contrary, fluctuations in the local currency versus the dollar are fully reflected in the ADR price. For example, Honda Motor Company's Yen-denominated stock declined by 6% on the Tokyo Stock Market for the full year 2022. Honda ADRs trade in the U.S. at a ratio of 1:1, or 1 ADR per share of Honda stock, but the U.S. ADR (ticker HMC) fell by 17% in 2022. The difference is accounted for by the 13% rise in the value of the dollar against the yen.
International stock returns have lagged the U.S. for eight of the past 10 years, causing many domestic investors to be overweight in U.S. equities. But an allocation outside the U.S. is an effective diversifier and foreign valuations are now extremely attractive relative to U.S. stocks.
For the average individual investor, the most efficient route to international diversification is through broad ETFs or mutual funds rather than individual securities. But for those who prefer to pick stocks and even for many professional fund managers, ADRs greatly simplify the complicated process of international investing.
Christopher A. Hopkins is a chartered financial analyst and co-founder of Apogee Wealth Partners