Must-Know for U.S. Stock Investment: A Comprehensive Understanding of American Depositary Receipts (ADR)

ADR Basic Overview

ADR (American Depositary Receipt) is an important tool for foreign companies to enter the US stock market. In simple terms, when a foreign enterprise wants to trade its shares on US stock exchanges, it issues ADRs to achieve this goal.

The core mechanism of ADRs is straightforward: foreign companies deposit their local stocks with a US depositary bank, which then issues corresponding depositary receipts. Investors can buy and sell these ADRs on NASDAQ, NYSE, or over-the-counter (OTC) markets.

For issuers, ADRs provide a relatively simple way to raise capital in US markets without going through the complex process of a full listing. For investors, ADRs significantly lower the barriers to investing in overseas companies—no need to open complicated foreign securities accounts, just trade them like regular US stocks.

The Significance of ADRs

Value for Foreign Companies

Many international companies are already listed domestically but are reluctant to go through a full US listing process again. However, the US capital market, as the largest and most active financing center globally, is highly attractive. Issuing ADRs becomes a compromise—avoiding the cumbersome process of secondary listing while enabling direct financing in the US market.

This approach is also applicable to large Taiwanese companies like TSMC, Hon Hai, and Chunghwa Telecom. After listing in Taiwan, they issue ADRs to trade simultaneously in US markets, greatly expanding their financing channels.

Value for Investors

If a foreign company does not issue ADRs, buying its shares involves many hurdles: opening a securities account in the relevant country, currency exchange, exchange rate risks, and a complex process that is both tedious and costly.

Conversely, companies with ADRs allow investors to trade in US dollars on familiar US exchanges, greatly simplifying operations and enabling global investors to participate more conveniently in diversified investments.

Classification and Levels of ADRs

Two Issuance Modes

Sponsored ADRs

Issued by a bank on behalf of the foreign company, with the company signing an agreement. The company retains control over the ADRs and pays issuance fees. The bank handles investor transactions. These ADRs must comply with SEC regulations and regularly disclose financial information.

Unsponsored ADRs

Banks can issue these without formal authorization from the foreign company. These securities carry higher risks and can only be traded OTC. Examples include Tencent(TCEHY.US), BYD (BYDDY.US), and Meituan (MPNGY.US).

Three Regulatory Levels

Based on the degree of access to the US market, ADRs are divided into Level 1, Level 2, and Level 3, with increasing regulatory requirements:

Level 1 ADRs carry the highest risk due to lighter regulation, minimal disclosure, and limited liquidity. Levels 2 and 3 are listed on major exchanges, offering better liquidity and transparency.

ADR Ratios: Not a 1:1 Correspondence

When investing in ADRs, it’s crucial to understand that ADR ratios are not always 1:1 with the foreign stocks.

For example, Taiwanese companies:

• TSMC: 1:5 (5 Taiwan shares equal 1 ADR)
• Hon Hai: 1:5
• Chunghwa Telecom: 1:10
• UMC: 1:5
• ASE Technology: 1:5

The ratio is mainly determined by the foreign stock price and exchange rate. If the stock price is too high, making trading less convenient for US investors, the company may adjust the ratio to improve liquidity.

Domestic Stocks vs ADRs: Key Differences

Taking TSMC as an example, traded both on Taiwan Stock Exchange and US markets:

The same logic applies to A-shares and A-share ADRs: BYD (00285) listed in China and traded as ADR in US (BYDDY); GWM (601633) A-shares and GWLRY ADR.

Key Factors to Watch in ADR Investment

Liquidity Risk

Foreign companies may be well-known domestically but less so in US markets, leading to fewer investors willing to trade their ADRs. For example, Chunghwa Telecom (CHT.US) had an average daily volume of about 145,000 shares in March, compared to 12.24 million shares traded daily in Taiwan—huge liquidity gap.

Poor liquidity can cause large bid-ask spreads and difficulty in quick transactions, especially problematic for frequent traders.

Company Fundamentals Analysis

Like any stock investment, ADR investing requires in-depth research into the company’s fundamentals: operational status, industry outlook, policy environment, etc. Notably, Level 1 ADRs are not required to disclose financial reports in the US, so investors need to proactively gather financial info published locally.

Premium and Discount Phenomena

ADR prices do not always move in sync with local stock prices. For instance, TSMC ADR surged 32% in early 2023, driven by China’s reopening, improved financial reports, and industry boom. However, short-term fluctuations can cause ADRs to trade at a premium or discount relative to the local stock.

Premium indicates the ADR’s price (converted) is higher than the local stock, reflecting overseas investors’ optimism. Discount is the opposite. Experienced investors often exploit these price differences for arbitrage.

For example, if the ADR’s converted price exceeds the Taiwan stock price, one might sell ADRs and buy the local stock to profit.

Advantages and Disadvantages of ADR Investment

Advantages

1. Lower Taxes and Fees

Compared to trading Taiwan stocks, ADRs generally incur lower transaction taxes and fees. Many foreign brokers offer zero-commission or very low-cost trading, which is advantageous for high-frequency traders.

2. Portfolio Diversification

While the US market mainly features US companies, ADRs allow investment in high-quality firms worldwide. Want to invest in electric vehicle companies? Besides Tesla (TSLA.US), you can also invest in China’s NIO ADR (NIO.US), achieving true global diversification.

Disadvantages

1. Complex Account Opening

Taiwan investors must open overseas brokerage accounts, convert TWD to USD, and transfer funds—this involves multiple fees and time costs. Using Taiwanese brokers to buy ADRs may incur high handling fees of 1%–2%.

2. Exchange Rate Risks

Since ADRs are priced in USD, fluctuations in TWD/USD exchange rates directly impact returns. For example, investing 30,000 TWD in ADRs at an exchange rate of 1:30 yields $1,000. If the ADR rises 20% to $1,200 but the exchange rate shifts to 1:25, converting back to TWD yields only 30,000 TWD—20% stock gain offset by currency loss.

Additionally, fluctuations in the local currency of the foreign company’s country against USD also affect ADR prices. Investors need to monitor both layers of exchange rate risk.

Summary

ADRs open a gateway for global investors to access international markets but also introduce new challenges different from traditional stock investing. Understanding how ADRs work, their classification levels, conversion ratios, and associated risks is essential for becoming a savvy investor. Whether investing in TSMC, NIO, or other ADRs, the best approach is to thoroughly understand their structure and features before making decisions aligned with your risk tolerance and investment goals.