Going global? Consider ADRs

There’s a whole big world of investing opportunities out there, yet many investors have shied away from international markets, concerned about the costs, complexity and potential risks. You may be able to minimize risks and gain a convenient avenue to deal in foreign markets is with American Depositary Receipts, or ADRs. An ADR is a negotiable certificate issued by a US bank representing a specified number of shares in a foreign stock that is traded on a US exchange.

The importance of these ADRs becomes clear when you realize the effect they can have on your portfolio. Being able to include holdings outside of the US can mean lower overall volatility in your portfolio and higher average returns due to the diversified investments. Keep in mind, however, that we believe true diversification comes from having enough of these holdings. We feel a good benchmark is having 25 to 30 ADRs or more to be well-diversified in this area.

The convenience of ADRs comes from the fact that investors do not have to deal with trading on foreign exchanges or with currency conversion, which has long been an impediment to many investors. You can buy ADRs just like shares of domestic companies, such as IBM or Coca-Cola. In addition, ADRs are denominated in US dollars, with dividends paid in US dollars. They are treated similar to US-based stocks when it comes to taxes, although the country issuing the stocks may include a withholding tax and the issuing depositary bank may charge an administration fee.

You can find ADRs in about 70 countries. These countries want to offer ADRs because they get more US exposure, allowing them to tap into the robust North American equities markets. Keep in mind, however, that not all foreign companies have ADRs available. For example, you can purchase ADRs for Japan’s Toyota Motor company but not for Germany’s BMW company.

How do they work? US banks purchase a bulk lot of shares from the company, bundle the shares into groups, and reissue them on either the New York Stock Exchange, the American Stock Exchange or the Nasdaq. The foreign company must provide the sponsor bank with detailed financial information. The international depositary bank sets the ratio of US ADRs per home-country share, with the result that the majority of ADRs are between $10 and $100 per share.

Additionally, there are three levels of ADRs. Level 1 ADRs are not listed on an exchange, but instead are found on the over-th- counter market. Many foreign companies get their feet wet with ADRs in Level 1, where they can gauge interest of the US in their securities. Level 2 securities are listed on an exchange, with more requirements from the SEC than Level 1. The most prestigious ADRs are Level 3. They are able to raise capital and gain substantial visibility in US financial markets.

As a rule, the foreign companies issue financial reports in English and file disclosure statements with the SEC. If satisfactory, they are then permitted to raise capital directly from US investors. The new stock is designated to be represented by ADRs.

A good rule of thumb: If you are just starting out with international investing, you might do better with other products that are available before you plunge in to ADRs. Keep in mind as well that foreign investments in general involve greater risks than US investments. These include the risk of currency fluctuations, which could be due to the country’s instability, economic risks and political risks. Ask your financial advisor if you have questions.