What is the difference between buying stocks in foreign markets, versus buying ADRs and OTCs in the United States?
I am interested in diversifying my portfolio. I've come across some companies that have their primary listings in foreign markets. I'm curious about the viability of investing in their American Depository Reciepts (ADRs) - some are on the OTC market - versus buying on the foreign exchanges. What is the risk involved in doing this?
Thank you for your question, it is an excellent one. First, I wanted to attach some definition around what you are inquiring about, for folks that may not understand the terms you have used.
ADR – American Depository Receipt – a foreign stock whose shares are held with an US financial institution and thus denominated in US Dollar (USD). Since it is traded in USD and in US markets it is subject to SEC oversight as well as the other bodies that govern the US markets.
OTC – Over-the-counter – stocks that are traded electronically and not reserved to trade on a specific exchange, like the New York Stock Exchange (NYSE) for instance. ADRs can be purchased OTC
The clear benefits of ADRs are as follows:
* They are traded in USD, thus the investor does not need to exchange foreign currencies in order to transact in a stock. While ADRs are still subject to currency risk, since the underlying company is a foreign company and traded in a foreign currency, the investor does not need to perform the actual currency transaction. Consider being an investor in China, Germany and Australia and wanting to buy shares on those markets. As an investor you would need to own currency in all three of those countries in order to transact and also perform those trades on foreign exchanges. If instead you transact in ADRs you only need to worry about buying/selling in USD and trading on US exchanges.
* Since an ADR is trading on a US exchange they are subject to some of the oversight of the exchange as well as the SEC (Securities and Exchange Commission).
* They are required to produce financial data and share it with investors – while this may seem rudimentary, the reporting requirements in other countries may not be as stringent as in the US.
* Access to some foreign markets that may have tight barriers to entry.
* If an ADR pays a dividend it is still a foreign currency payment and may be subject to mandatory withholding per the treaty with that country. For instance, if the treaty with country ABC is 15% and you receive a $1 dividend, you will only see $0.85 credited to your account. You may need to consult a tax professional to assist with reporting these transactions properly.
* ADRs are subject to currency/exchange, political and inflation risk of the home country
Hope this answers your question. Please note that the following text should not serve as a recommendation to buy or sell securities but should be instead treated as educational material. If you have any further questions, please do not hesitate to contact me.
You are much better off buying ADRs. The ADRs trade in this country, pay their dividends in dollars, and you can execute orders in your time zone. Granted, ADRs tend to be more illiquid than the underlying ordinaries but unless the dollar size of your portfolio holdings run into the hundreds of thousands you should be able to get in and out with no issues. It's also true that brokerage houses deal only in ceratin foreign markets and might charge a currency-conversion fee. The return to an ADR investment will be identical to the US dollar return of the foreign share.
The major benefit to purchasing ADRs instead of purchasing the stock on a foreign market is taxes. Let's say for instance that the company you want to buy is in Germany and traded on their stock exchange. If you own it directly, then you will be taxed by both the US and Germany. If you own it thru an ADR, you will only be taxed by the US (assuming you didn't use a tax protected account).
My recommendation is to always stick with the ADR to avoid paying excessive taxes.