Key takeaways

• An American depositary receipt is a certificate issued by a U.S. bank that represents shares in foreign stock.

• ADRs represent an easy, liquid way for U.S. investors to own foreign stocks.

• The pros of ADR include easy to track and trade, available through U.S. brokers, etc. And the cons of ADR are double taxation, the limited selection of companies...

What is ADR？

The term American depositary receipt (ADR) refers to a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares—usually one share—of a foreign company's stock. 

The ADR trades on U.S. stock markets as any domestic shares would. ADRs offer U.S. investors a way to purchase stock in overseas companies that would not otherwise be available. 

Foreign firms also benefit, as ADRs enable them to attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges.

In order to begin offering ADRs, a U.S. bank must purchase shares on a foreign exchange. The bank holds the stock as inventory and issues an ADR for domestic trading. ADRs list on either the New York Stock Exchange (NYSE) or the Nasdaq, but they are also sold over-the-counter (OTC).

An ADR may represent the underlying shares on a one-for-one basis, a fraction of a share, or multiple shares of the underlying company. The depositary bank will set the ratio of U.S. ADRs per home-country share at a value that they feel will appeal to investors.

Because of arbitrage, an ADR's price closely tracks that of the company's stock on its home exchange. Remember that arbitrage is buying and selling the same asset at the same time in different markets. This allows traders to profit from any differences in the asset's listed price. 

Before American depositary receipts were introduced in the 1920s, American investors who wanted shares of a non-U.S. listed company could only do so on international exchanges—an unrealistic option for the average person back then.

ADRs were developed because of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. J.P. Morgan's (JPM) predecessor firm Guaranty Trust pioneered the ADR concept. In 1927, it created and launched the first ADR, enabling U.S. investors to buy shares of famous British retailer Selfridges and helping the luxury depart store tap into global markets. The ADR was listed on the New York Curb Exchange.

A few years later, in 1931, the bank introduced the first sponsored ADR for British music company Electrical & Musical Industries (also known as EMI), the eventual home of the Beatles.

Advantages and Disadvantages of American Depositary Receipts

As with any investment, there are distinct advantages and disadvantages of investing in ADRs. We've listed some of the main ones below.

• Advantages

As noted above, ADRs are just like stocks. This means they trade on a stock exchange or over the counter, making them fairly easy to access and trade. Investors can also easily track their performance by reviewing market data.

Purchasing ADRs is easy because they're available directly through American brokers. This eliminates the need to go through foreign channels to buy stock in a company in which you may be interested. And since they're available domestically, shares are denominated in U.S. dollars, which means you avoid any direct risks associated with fluctuations in currency rates.

One of the most obvious benefits of investing in ADRs is that they provide investors with a way to diversify their portfolios. Investing in international securities allows you to open your investment portfolio up to greater rewards (along with the risks).

• Disadvantages

The main problems associated with ADRs are that they may involve double taxation—locally and abroad—and how many companies are listed. Unlike domestic companies, there are a limited number of foreign entities whose ADRs are listed for the public to trade.

As noted above, some ADRs may not comply with SEC regulations. These are called unsponsored ADRs, which have no direct involvement by the company. In fact, some companies may not even provide permission to list their shares this way.

Although investors can avoid any of the direct risks that come with currency exchange, they may incur currency conversion fees when they invest in ADRs. These fees are established in order to directly link the foreign security and the one traded on the domestic market.

Difference between ADR and ADS

American depositary receipts (ADRs) allow foreign equities traded on U.S. stock exchanges. In fact, this is how the stock of most foreign companies trades in U.S. stock markets. Meanwhile, an American depositary share (ADS) is the actual U.S. dollar-denominated equity share of a foreign-based company available for purchase on an American stock exchange. 

For example, if a U.S. investor wanted to invest in CanCorp, the investor would need to go to their broker and purchase a number of ADRs that are equal to the amount of CanCorp shares that they want. In this case, the ADRs are the receipts that the investor has to purchase, whereas the ADSs represent the underlying shares (CanCorp) that were invested in.