A must-see for US stock investors: What exactly are ADR stocks?

ADR Quick Start Guide

American Depositary Receipts (ADRs) are an important tool for foreign companies entering the U.S. stock market. In simple terms, when overseas companies want to trade in the U.S., they do so by issuing ADRs—U.S. depositary banks convert foreign stocks into ADR certificates, allowing investors to trade them just like regular U.S. stocks.

What does this mean for investors? You can buy and sell these foreign company stocks directly on Nasdaq, NYSE, or OTC markets without opening local accounts or currency exchanges. But you also need to pay attention to liquidity risks, exchange rate fluctuations, and regulatory differences among various levels of ADRs.

How Do ADRs Work? Understanding the Issuance Mechanism

Foreign companies deposit their local stocks with U.S. depositary banks, which then issue corresponding ADR certificates. This allows the stocks to circulate in the U.S. market.

Taking TSMC (TSM.US) as an example, a leading company listed on the Taiwan Stock Exchange and also issuing ADRs on the NYSE, meeting the needs of investors in different regions. For companies, issuing ADRs is simpler and cheaper than secondary listings; for investors, trading becomes extremely convenient—just like trading any other U.S. stock.

There are two key categories of ADRs: Sponsored ADRs are issued under the company’s guidance and must comply with SEC disclosure requirements; unsponsored ADRs may involve no direct company participation and are traded over-the-counter, carrying higher risks. Tencent (TCEHY.US), BYD (BYDDY.US), and others fall into the unsponsored ADR category.

Three Levels of ADRs: Balancing Risk and Liquidity

ADRs are classified into three levels based on their access to the U.S. market:

Level 1 ADRs are traded only over-the-counter, with the loosest regulations. Companies are not required to file financial reports with the SEC, providing minimal disclosure. These ADRs have relatively weak liquidity and security.

Level 2 ADRs are listed on Nasdaq or NYSE, requiring compliance with stricter regulations. Companies must submit financial forms like F-20, significantly improving liquidity.

Level 3 ADRs have the strictest regulations and also serve as a financing tool. Companies need to file more complex reports (including F-1, F-3, F-4, etc.), providing investors with the highest level of transparency and protection.

ADR Ratios: Not a 1:1 Conversion

This is a detail that investors new to ADRs often overlook: ADRs and local stocks are not always 1:1.

For example, Hon Hai (Foxconn) has a conversion ratio of 1:5, meaning 5 shares of Taiwan Hon Hai (2317.TW) equal 1 U.S. ADR (HNHPF.US). The company sets this ratio based on foreign stock prices, exchange rates, and liquidity needs—if the stock price is too high, it can hinder trading convenience, so companies adjust ratios to optimize the investment experience.

Here are some well-known Taiwanese companies’ ADR ratios: TSMC is 1:5, Chunghwa Telecom (CHT) is 1:10, UMC is 1:5, and ASE Technology (ASX) is 1:5.

Taiwan Stock vs. Taiwan Stock ADR: Six Key Differences

If you follow both Taiwan stocks and ADRs, understanding these fundamental differences is essential:

Nature: Taiwan stocks are actual shares, while ADRs are certificates representing those shares.

Trading Venue: Taiwan stocks are traded on the Taiwan Stock Exchange under Taiwanese regulation; ADRs are traded on U.S. exchanges under SEC regulation. This affects trading hours, rules, and taxes.

Stock Codes: Hon Hai’s Taiwan stock code is 2317, while its ADR code is HNHAY—completely different identification systems.

Investor Base: Taiwan stocks mainly target local investors; ADRs serve global investors, affecting liquidity and participation.

Conversion Ratios: As mentioned, the number of shares involved in trading is not 1:1.

Premiums and Discounts: Although their movements are generally correlated, due to market sentiment, liquidity, and exchange rates, daily prices of Taiwan stocks and ADRs can diverge, creating premiums or discounts. When ADR prices are relatively high, it’s called a premium; when low, a discount.

A-shares and A-shares ADRs: Cross-Border Investment Options

The differences between A-shares and A-shares ADRs are similar to those with Taiwan stocks. BYD (00285) is listed on the Shenzhen Stock Exchange and also issues ADRs (BYDDY) for U.S. investors. A-shares are regulated by China’s CSRC, while A-shares ADRs are under the U.S. SEC framework. The investor groups are entirely different, directly impacting liquidity, valuation, and volatility.

Key Factors to Consider When Investing in ADRs

Liquidity issues cannot be ignored

Many foreign companies are highly recognized locally but less known in the U.S. market. Plus, the number of ADRs issued is limited, and trading participants are fewer than in the local market. For example, China Telecom (CHT.US) had an average daily trading volume of only 145,000 shares in March, compared to 12.24 million shares daily in Taiwan—huge gap. Low trading volume can lead to wider bid-ask spreads and higher liquidity risks.

Fundamental analysis is essential

Just like investing in any stock, investing in ADRs requires understanding the company’s operations, industry outlook, and policy support. Especially for Level 1 ADRs, companies are not required to disclose financial reports in the U.S., so investors must actively review financial information released locally. In early 2023, TSMC’s ADR surged 32%, driven by pandemic reopening, positive earnings reports, and optimistic chip industry prospects.

ADR premiums and discounts present trading opportunities

Prices of ADRs and local stocks are not perfectly synchronized. When premiums (ADR relatively more expensive) occur, experienced investors may sell ADRs and buy local stocks, and vice versa, profiting from arbitrage. The calculation involves converting ADR prices by ratio and comparing with local closing prices.

Pros and Cons of Investing in ADRs

Advantages: Compared to other investment methods, ADRs have unique appeal. Taiwanese investors trading ADRs with gains under 1 million NT$ do not need to pay income tax, and overseas brokers often charge much lower fees than Taiwanese brokers (many even zero commission). Frequent traders can save significant costs. Additionally, ADRs open the door to international investment—allowing you to invest in Tesla (TSLA.US) and NIO (NIO.US) simultaneously, diversifying in the electric vehicle sector.

Disadvantages: Non-U.S. investors face operational complexities. You need to open an overseas broker account, convert local currency to USD, and transfer funds—each step incurs currency conversion costs. Using Taiwanese brokers to purchase ADRs usually costs 1-2%, which is more expensive than direct overseas broker trading.

More importantly, exchange rate risk: if you exchange 30,000 TWD for 1,000 USD and gain 20% profit to become 1,200 USD, but the exchange rate depreciates from 1:30 to 1:25, converting back to TWD yields only 30,000, erasing your profit. Large fluctuations between local currencies and USD also directly impact ADR prices.

Summary

ADRs offer convenience for global investors but are not without risks. Before investing, thoroughly evaluate liquidity, exchange rate risks, company fundamentals, and regulatory differences among ADR levels. Only after understanding these factors can you participate more confidently in the U.S. stock market and international investments.