Before the invasion of Ukraine, one of the ways Americans could invest in Russia was through American depositary receipts of Russian companies.
These certificates issued by banks represented shares in Russian companies traded on the Moscow Stock Exchange, including Gazprom, a major natural gas supplier to Europe; Norilsk Nickel, a large producer of the metal that is key for electric vehicle batteries; and Polyus, one of the largest gold producers in the world.
But in the financial fallout from the war, Russia passed a law requiring these ADRs to be delisted and converted into the underlying Russian shares, effectively leaving them in limbo because already-existing U.S. Treasury Department sanctions meant U.S. investors couldn’t open accounts with brokerages doing business in Russia.
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“Many U.S. investors in these delisted securities have effectively lost the ability to access their investment,” according to accountancy and advisory firm PKF O’Connor Davies.
It’s a cautionary tale about what can happen when using ADRs to invest in foreign companies. At the same time, there are good reasons for investing in ADRs, just probably not in countries involved in heightened geopolitical conflict. After all, some of the most recognizable companies in the world trade in the U.S. via ADRs, such as Unilever PLC (ticker: UL), Sony Group Corp. (SONY) and Toyota Motor Corp. (TM).
If you’re curious about American depositary receipts, here are some things to know about ADRs:
— What is an American depositary receipt (ADR)?
— How American depositary receipts work.
— Advantages of American depositary receipts.
— Disadvantages of American depositary receipts.
What Is an American Depositary Receipt (ADR)?
ADRs are certificates issued by U.S. banks or brokers that represent shares in a foreign company. They can represent one or multiple shares or fractions of shares.
These receipts trade on the New York Stock Exchange, Nasdaq and over the counter (OTC) in U.S. dollars, making it easier for domestic investors to gain exposure to foreign jurisdictions and companies that might appeal to them for various reasons.
You can exchange your ADR holdings for shares traded on the foreign market, but most people don’t because they want the ease of the ADR on U.S. exchanges.
How American Depositary Receipts Work
If you want to invest in ADRs, say, to get exposure to a specific company you like or to make a bet on a foreign jurisdiction you think may be overlooked, you can buy them from your broker or dealer just like you would a normal stock.
That’s pretty simple, but it’s worth understanding what goes on behind the scenes for those ADRs to be issued.
To issue American depositary receipts, a U.S. bank purchases shares in the foreign company on a foreign exchange. It can then issue ADRs in the place of those shares that it holds.
Sponsored ADRs and Levels
Foreign companies can sponsor ADRs by creating an agreement with a U.S. bank. These types of ADRs come in three tiers: Level 1 ADRs have the least reporting requirements and are only traded over the counter; Level 2 and Level 3 ADRs have increasing levels of reporting requirements and can be traded on the NYSE or Nasdaq.
Unsponsored ADRs
There are also unsponsored ADRs, where a U.S. bank issues an ADR without the participation of the foreign company. These can only be traded over the counter. Also, there can be multiple listings of this type of ADR for a single company, as opposed to sponsored ADRs, which are unique.
[SEE: 8 Things to Know Before You Invest in Gold.]
Advantages of American Depositary Receipts
One of the primary advantages of ADRs is the ease they afford investors when it comes to investing in foreign stocks.
“ADRs can be a convenient way for many Americans to gain exposure to foreign markets and diversify their portfolios,” says Thomas Brock, a chartered financial analyst and expert financial reviewer for Annuity.org. “ADRs allow U.S. investors to buy and sell shares of foreign companies without having to deal with foreign stock exchanges and currencies.”
Streamlined Process of Trading and Investing in ADRs
Investors might have to open an account with a local broker if their U.S. broker doesn’t allow trading on local exchanges or doesn’t allow trading on a certain foreign stock exchange they wanted to access. ADRs bypass this hassle.
Better Liquidity of ADRs on U.S. Exchanges
Daniel Bustamante, managing partner and chief investment officer of asset manager Bustamante Capital, adds that liquidity when trading ADRs on U.S. exchanges is often better than on foreign exchanges, where buyers and sellers might be less prevalent.
Disadvantages of American Depositary Receipts
Despite the convenience, there are drawbacks to ADRs:
Access to the Underlying Company’s Performance Data
Depending on the type of ADR and their regulatory requirements, investors have differing levels of information at their fingertips with which to gauge the health of the foreign company.
Costs of Issuing and Maintaining ADRs
ADRs can be more expensive than investing in domestic stocks because of depository fees, administrative expenses and currency conversion costs, says Brock. Even though ADRs mean U.S. investors don’t have to deal with converting currencies themselves, the bank issuing the ADRs will deduct enough to cover currency conversion expenses.
“The costs can be exacerbated by relatively wide bid-ask spreads, a marketplace norm for many thinly traded ADRs,” Brock says. “Finally, unlike domestic stockholders, ADR holders typically do not have voting rights over corporate governance matters.”
Exchange Rate Risk of ADRs
Also, there is exchange rate risk. All else being equal, if the foreign currency declines, the value of the ADR will decline as well.
Taxation can also be a headache. If the foreign country where the company is located taxes dividends or capital gains, investors will need to file a special form with the Internal Revenue Service to avoid double taxation.
Risk of ADR Delisting
There is also the risk that an ADR could be delisted. Normally, if that happens, investors can swap the ADR for the foreign stock. They could keep the stock and continue to collect dividends or capital gains, or they could work with a broker in the foreign market to sell them.
“However, it will only be marketable to non-American investors, which is certain to put downward pressure on its value,” Brock says.
Risk of Economic and Geopolitical Upheaval
But, as with the case of Russian ADRs, if U.S. investors can’t access those foreign markets, they may be faced with not having access to their stock.
There is also the risk that geopolitical events might hurt the foreign company, reducing its share value and thus the value of its ADRs, even if they’re not delisted.
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American Depositary Receipts: Pros and Cons of ADR Investing originally appeared on usnews.com
