Must-Read for U.S. Stock Investment | What Exactly is an ADR? A Guide to Understanding the Investment Logic of American Depositary Receipts

What is ADR? A Quick Overview of Core Concepts

ADR (American Depositary Receipt) is a financial instrument representing foreign stocks, issued by U.S. depositary banks. In simple terms, when foreign companies want to raise funds or trade in the U.S. market, they typically do so by issuing ADRs. The advantage of this approach is that U.S. investors can invest directly in these foreign companies without needing to open accounts with foreign brokers.

For example, TSMC (TSM.US), BYD (BYDDY.US), and Great Wall Motors (GWLLY.US) are well-known ADR representatives. Investors can trade these ADRs on the New York Stock Exchange, NASDAQ, or OTC markets just like regular U.S. stocks.

How ADR Works and Its Classifications

How ADR operates

Foreign companies deposit their shares with U.S. depositary banks, which then issue equivalent ADR certificates. This process allows foreign stocks to circulate in the U.S. securities market. For investors, ADRs and stocks are virtually indistinguishable; they can be simply understood as foreign company stocks issued in the U.S..

Types of ADRs

Sponsored ADRs are actively issued by foreign companies, which sign agreements with banks, maintaining control over the ADRs and paying related fees. These ADRs comply with SEC regulations, require regular financial disclosures, and carry relatively lower risks.

Unsponsored ADRs are issued unilaterally by depositary banks, sometimes without foreign company involvement. These ADRs can only be traded OTC and are riskier. Tencent (TCEHY.US), BYD (BYDDY.US), and Meituan (MPNGY.US) are examples of unsponsored ADRs.

Three Levels of ADRs

Based on regulatory standards for entering the U.S. market, ADRs are divided into three levels:

Level 1 ADRs have minimal disclosure and lowest liquidity. Levels 2 and 3 can be traded on major exchanges with higher compliance requirements.

Key Differences Between ADR and Local Stocks

Comparing Taiwan Stocks and Taiwan ADRs

Investors often ask: How does TSMC (TSM.US) ADR differ from buying TSMC (2330) shares in Taiwan? The answer involves multiple aspects:

Nature and Conversion Ratios: Taiwan stocks are actual shares; Taiwan ADRs are depositary receipts. Most importantly, they are not 1:1 convertible. For example, TSMC’s conversion ratio is 1:5, meaning 5 Taiwan shares equal 1 ADR. Hon Hai (HNHAY.US) also has a ratio of 1:5, while Chunghwa Telecom (CHT.US) is 1:10. Conversion ratios mainly depend on stock prices, exchange rates, and liquidity considerations.

Trading Venues and Regulations: Taiwan stocks are traded on the Taiwan Stock Exchange under Taiwanese regulation; ADRs are traded on U.S. exchanges under SEC oversight. This results in differences in trading rules, hours, and tax treatments.

Trading Volume Differences: For example, Chunghwa Telecom’s ADR has an average monthly trading volume of about 145,000 shares, whereas in Taiwan, the same period’s average monthly volume reaches 12.24 million shares. ADR liquidity is generally much lower than local markets, which can lead to larger bid-ask spreads.

Premiums and Discounts: Although Taiwan ADRs tend to follow the same trend as local stocks, due to exchange rate fluctuations and investor sentiment, their prices can differ. When the ADR price, after conversion, is higher than the local stock price, it’s a premium; otherwise, it’s a discount. For example, on March 22, 2023, TSMC ADR closed at $92.6, which converts to 553.3 TWD ($92.6 ÷ 5 × 30), while the Taiwan stock closed at 533 TWD, showing a premium.

Comparing A-shares and A-shares ADRs

The same logic applies to the A-share market. BYD (BYDDY.US) and Great Wall Motors (GWLLY.US) have ADRs traded in the U.S., while their A-share versions (BYD 00285, GWM 601633) are traded on Chinese exchanges. They are under different regulatory authorities, with distinct investor bases—A-shares mainly for Chinese investors, ADRs mainly for overseas investors.

Factors to Consider Before Investing in ADRs

Liquidity Risk

When investing in ADRs, first assess liquidity. Since foreign companies are usually less known internationally than locally, fewer investors are willing to trade ADRs. Additionally, ADR issuance volumes are often lower than local stocks, which can lead to larger bid-ask spreads.

Exchange Rate Fluctuation Risk

ADR trading involves currency exchange with USD, and exchange rate fluctuations directly impact returns. For example, if an investor uses a 1:30 exchange rate to convert 30,000 TWD (equivalent to $1,000) to buy ADRs, and gains 20%, the total becomes $1,200. But if the exchange rate shifts to 1:25, converting back to TWD yields only 30,000 TWD, meaning no real profit. Moreover, fluctuations in the foreign company’s local currency against USD can indirectly affect ADR prices.

Company Fundamentals Assessment

Investing in ADRs is similar to investing in regular stocks; you need to evaluate the company’s operational status, industry outlook, policy environment, etc. Notably, Level 1 ADRs in the U.S. do not require financial disclosures, so investors must review financial reports published by the company in its home country. For example, TSMC’s ADR surged 32% in early 2023, driven by China’s reopening, strong financial performance, and optimistic industry prospects.

Advantages of Investing in ADRs

Tax Benefits

For Taiwanese investors, profits from ADR trading under 1 million TWD are tax-exempt. Additionally, since there are no transaction taxes, the tax burden is much lighter compared to trading in Taiwan stocks.

Lower Transaction Fees

Overseas brokers’ transaction fees for ADRs are much lower than those in Taiwan, with many offering zero-fee services. For frequent traders, choosing ADRs can significantly reduce trading costs. In contrast, purchasing ADRs through Taiwanese brokers involves paying 1%-2% in commissions.

More Investment Options

Investing in ADRs opens up global investment opportunities. For example, if you want to invest in electric vehicles, you can choose U.S. Tesla (TSLA.US) or Chinese NIO (NIO.US), diversifying your portfolio.

Challenges and Limitations of Investing in ADRs

Relatively Complex Account Opening

For non-U.S. investors, investing in ADRs involves multiple steps: opening an overseas broker account → currency exchange into USD → depositing funds for trading. Each step incurs costs, especially currency exchange fees. In comparison, direct investment in Taiwan or A-shares is more straightforward.

Difficulty in Accessing Information

Since ADR trading mainly targets overseas investors, relevant information may not be as comprehensive as in local markets. Investors need to research foreign market dynamics and company financials themselves, increasing the difficulty of making informed decisions.

Policy and Exchange Rate Risks Coexist

Besides company operational risks, investors must also bear currency fluctuation risks and cross-border policy risks. These external factors can unexpectedly impact ADR prices.

Summary

ADRs provide a convenient channel for global investors to access international markets, allowing U.S. investors to easily invest in foreign quality companies and foreign investors to participate in the U.S. stock market through familiar trading methods. However, before investing, it is essential to fully understand key factors such as liquidity, exchange rate risks, and disclosure requirements, so as to be well-informed and capable of seizing opportunities while avoiding risks in ADR investments.