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ADRs: Invest Offshore Without Leaving Home

by Todd Shriber

It was April 1927. Calvin Coolidge was president, and noteworthy events that die-hard historians or baseball fans may recall include the Italian anarchists Saccho and Vanzetti receiving their death sentences and Babe Ruth hitting the first of his 60 home runs, - a single-season record at the time. For investors, a third event in April 1927 has proved equally important and far more profitable: the debut of American depositary receipts (ADRs).

An ADR represents ownership of shares in a foreign company, but it can be bought and sold just like any U.S. stock, allowing investors to diversify their portfolios with foreign assets, but skip the hassle of a foreign brokerage account. Sound intriguing? Find out how these securities work and what they can add to your portfolio.

History of the ADR and Current Stats

John Piermont Morgan (yes, that J.P. Morgan), launched the first ADR for the U.K.'s Selfridges Provincial Stores Limited, the famous retailer now known as Selfridges Plc. Even the audacious J.P. Morgan probably had no idea of the trend he was touching off. As of mid-2008, there were more than 2,250 depositary programs representing more than 1,800 companies from over 70 countries listed on global stock exchanges. According to the Bank of New York Mellon, in the first half of 2008, 52 billion shares of ADRs changed hands, representing a value of $2.07 trillion.

Benefits of ADR Investing

Some benefits of ADR investing are clear. First, many international markets, especially emerging markets, have higher GDP growth rates than the United States or Europe. While the American stocks in your portfolio may be stagnating, holding a few ADRs has the potential to provide you with solid returns during downturns in domestic markets. Your broker and the financial media are always advocating diversification; ADRs represent a great avenue to diversify your portfolio.

Another benefit investors can realize through ADR investing is favorable currency conversions for dividends and other cash distributions. For example, if you own shares of a European ADR and the euro is strong against the dollar, a dividend increase will be that much more rewarding because the dividend payment has to be converted to dollars.

The most obvious benefit of ADRs is that they make international companies that investors would normally have to pay a premium for (or perhaps be unable to buy at all) more accessible. If you want to buy 100 shares of Petrobras, the Brazilian oil giant, all you need to do is call your broker or log onto your online brokerage account. There's no need to find a distant relative living in Brazil to execute the trade for you.

Perils and Pitfalls

As buyers of ADRs, we treat them as we would any other securities purchase: we want to profit. However, there are issues that can arise with ADRs that aren't always germane to domestic stocks. Let's use a 2008 geopolitical conflict to highlight a potential peril. Say you own some shares of a Russian oil ADR, and neighboring country Georgia's military is able to knock out a couple hundred miles of pipeline. As far-flung as it seems, this scenario could come to bear, especially in a developing nation. The same goes for political unrest. It's probably best to identify dictators and not invest in companies based in nations that are ruled by these leaders, as these countries are more prone to political strife.

Of course your ADR investments are subject to some of the same risks as your domestic investments, including credit, currency and inflation risk. These should be taken into account, regardless of the state of the market. There are some markets, such as Australia and Canada, where the local currencies are tied directly to commodity prices. If gold or oil is going up, this contributes to a rise in those currencies. Of course, when those commodities fall, the currencies fall in tandem. This is just one more factor an investor needs to take into account.

There are levels of ADRs on U.S. markets. For example, a Level I ADR trades over the counter and as such, is highly speculative. Those shares probably aren't liquid and, what's worse, information on the company is scant. Keep in mind that many countries don't require their public companies to report results quarterly like the U.S. does. For better or worse, Level I issues are the fastest-growing segment of the ADR market, according to the Bank of New York Mellon.

Thinking of buying that Chinese solar company that trades 20,000 shares a day at $1.50? It's probably best to wait for it to graduate to the Nasdaq or NYSE. Level II and III ADRs are where investors want to be. These are the ADRs that trade on major U.S. exchanges and must uphold the same general reporting rules and SEC regulations as American-based corporations.

Tax Treatment of ADRs

Tax treatment of ADRs by the IRS is generally the same as for domestic investments. Investors are subject to the same capital gains and dividend taxes at the same rates. There is a little twist, however: many countries will withhold taxes on dividends paid. While the American investor must still pay U.S. income tax on the net dividend, the amount of the foreign tax may be claimed by the investor as a deduction against income or claimed against U.S. income tax. Investors are encouraged to consult a professional tax or investment advisor to make sure they are recording (and paying taxes on) their ADR investments properly.

Conclusion

Investors should look beyond the confines of the U.S. borders in an effort to diversify and maximize returns. Many investors ignore the foreign-equity asset class entirely, and this is not beneficial to their portfolios. ADRs are one way to diversify your portfolio and help you achieve better returns when the U.S. market is in a slump.