American Depositary Receipts, or ADRs, are one of the most important items in an international investor's tool kit. To see why, let's consider the following example.
Say you're interested in investing in France. One option is to open a brokerage account in Paris, wire some money over there, convert your dollars into Euros, and then go shopping for French stocks. To say the least, this would be a difficult and time-consuming process. And your accountant would hate you at tax time.
ADRs are designed to eliminate these hassles. An ADR is a security that represents ownership of shares of a foreign company. When you buy an ADR, you technically don't own the foreign stock directly. Instead, you own a piece of paper that entitles you to one or more shares of a foreign stock being held on your behalf at a depositary bank.
The first ADR was created in 1927 by J.P. Morgan, to allow Americans to invest in shares of Selfridges, a British department store. Today there are more than 2,200 ADRs available, representing shares of companies located in more than 70 countries. The Bank of New York, JPMorgan, Deutsche Bank and Citigroup are among the leading depositary banks, which create and issue ADRs.
The popularity of ADRs has surged over the years because they have a number of distinct advantages that appeal to both small investors and professional money managers alike.
Advantages of ADRs
- ADRs can be bought and sold just like shares of IBM or Coca-Cola.
- You don't need a foreign brokerage account or a new broker; you can use the same broker that you normally deal with.
- Prices for ADRs are quoted in U.S. dollars, and dividends are paid in dollars.
- ADRs trade during U.S. market hours and are subject to similar clearing and settlement procedures as American stocks.
- You can customize your portfolio however you like, depending on which countries or sectors you are interested in.
Disadvantages of ADRs
By the same token, ADRs have some important limitations and drawbacks.
- Limited selection: Not all foreign companies are available as ADRs. For example, Japan's Toyota Motor has an ADR, but Germany's BMW does not.
- Liquidity: Plenty of companies have ADR programs available, but some may be very thinly traded.
- Exchange rate risk: While ADRs are priced in dollars, for sake of convenience, your investment is still exposed to fluctuations in the value of foreign currencies.
- Because ADRs are like stocks, you need to buy enough of them to ensure adequate diversification. So if you don't have enough investment capital to spread around, say 25 to 30 ADRs (or more), you won't be able to create a truly diversified portfolio on your own.
The Bottom Line
Once you have a bit of international investing experience under your belt, ADRs can be a powerful tool to customize your portfolio or make targeted investments in specific companies, sectors and countries. But if you are just getting started in international investing, it's much easier to stick with a good international mutual fund or ETFs until you have a firm grasp of the basics.