If you’re looking for a relatively easy way to diversify your portfolio with international investments, you may want to consider trading ADRs. 

ADRs offer investors a hassle-free way to purchase shares of international companies without having to deal with foreign markets or contend with hefty overseas banking fees. 

Here’s a comprehensive overview of what ADRs are so that you can decide whether they’re an investment method of interest to you.

What Does ADR Mean?

ADR stands for American Depositary Receipt (sometimes also spelled depository). 

An ADR is a security that allows foreign companies to trade on the US financial exchanges. 

A Practical Example of Trading ADRs

Think of it this way: 

Say you wanted to buy shares of the stock of a Swiss chocolate company. You’d need to set up a Swiss brokerage account, deal with converting currencies, overseas bank fees, time-zone differences, and many more headaches. 

However, ADRs allow you an easier option for investing in the company. 

ADRs allow shares of the non-U.S. company to be traded on the U.S. exchanges via depositary banks that manage the currency and local tax issues. These shares or securities are called American Depositary Shares (ADSs). 

So, it’s a way to easily invest in a business like the aforementioned Swiss chocolate company without having to jump through so many hoops.

How Do American Depositary Receipts Work?

If you’re not buying shares of a foreign stock directly, how do ADRs work?

It starts with a foreign company wanting to be listed on the U.S. exchanges.  Provided that they meet certain requirements, they can issue a depositary receipt, which can be traded like stocks. 

Let’s go back to the example of the Swiss chocolate company. Say this company wants to be listed on the U.S. exchanges. The way it moves forward is that a U.S. broker purchases the shares from the company, then they’re handled through a local custodian bank while they make their way to the depositary bank. 

Now, to press pause for a moment, if you’re not familiar with the term custodian bank, according to Investopedia, it’s “a financial institution that holds customers’ securities for safekeeping so as to minimize the risk of their theft or loss. A custodian holds securities and other assets in electronic or physical form.” 

Basically, this is the place that holds shares for a holding period. 

Then, it’s off to the depositary bank. This is the U.S. institution responsible for issuing the ADRs in the United States. Now, both banks verify that the shares have traversed as needed, and the depositary bank can give the ADRs to the broker who initiated the purchase. 

Once the ADRs are issued, it can be traded on the stock exchanges. 

All of the transactions will take place as if they were regular stock exchange transactions, and will be conducted in U.S. dollars, with the same rights and privileges of regular stock shares. 

Mechanism of American Depositary Receipts

You may be wondering how the shares translate to the U.S. market. 

We’ll get more into the ratio in a bit, but the short answer is that each ADR may represent either a single or more, local shares of the foreign stock in question. 

The price will be issued in dollars, converted from the local currency price. There are several types of ADRs: sponsored, unsponsored, Level I, Level II, and Level III. Let’s go through those right now. 

Sponsored and Unsponsored

Most ADRs are what is called sponsored, based on who is acting as the issuer.  However, there are also some ADRs which are considered unsponsored.

Unsponsored ADR shares are traded on the OTC (which stands for ‘over the counter’) market. They’re issued based on market demand; there’s no formal agreement between the foreign company and a depositary bank. 

Actually, unsponsored ADRs might be issued through multiple depositary banks. This can be confusing because while the ADRs might be through the same company, the respective banks will only service the shares they have issued. 

Level I

The lowest level of sponsored ADRs, and incidentally the most common, are issued via a Level 1 program. This is because it’s the easiest and quickest way for a foreign company to have ADRs issued in the USA. 

With a Level 1 sponsored ADR, there is a single designated depositary, which is also the agency which facilitates the transfer. 

These Level 1 shares are only available to be traded over the OTC market. There are minimal requirements with the SEC, and there are no requirements for quarterly or annual reports. 

This might start sounding like penny stocks. 

However, unlike a company offering penny stock shares, the overseas company in question does have to be listed on at least one or more foreign exchanges and must have information in English, including its domestic annual report.

Sometimes, companies will start with a Level 1 listing and then upgrade to one of the higher levels in time. 

Level II

It starts to get a little more complicated for the foreign company as the level of sponsorship gets higher.

If an overseas company wants to have a Level II standing, it has to jump through a few more hoops. They have to file with the SEC and is held to SEC regulations. 

The company must also file a Form 20-F, which is like their version of an annual report for a U.S. company. 

They’re also required to meet certain standards, such as the US GAAP (Generally Accepted Accounting Principles) or the IFRS (International Financial Reporting Standards). 

It’s a lot more work, but when a company has Level II status, they can be listed on one of the bigger exchanges, such as the NYSE or NASDAQ. 

It must meet the exchange’s requirements too, of course, otherwise, it could be delisted or downgraded. 

The advantage is that they have greater visibility and greater legitimacy. 

Level III

As you probably guessed, Level III status is like being part of the Captain’s club at the airport. It’s the highest level that a foreign company can attain in the ADR-sphere. 

But with great power comes great responsibility, so there are a lot more rules that they have to stick to and standards that must be met. 

Actually, the rules are even more strict than the standards that most U.S. companies must meet.

A Level III program requires this because it’s actually a bigger offering for the company. They are not only letting shares from their home country be deposited so that they can be traded in the USA. 

They are issuing additional shares for the foreign market in hopes of raising capital. 

To do this, they are required to issue a prospectus for the shares in form of Form F-1. They also have to meet all of the same standards listed above for Level II. 

Because they rely on the U.S. shareholders more heavily, they give them more information. In general, you can find information on Level III companies really easily. 

This means that as an investor, you can easily access their reports, press releases, and more. 

ADRs and common stock actually seem similar at first. But it’s their differences really set them apart. You need to understand these differences before you determine whether or not you want to start investing.