Introduction to U.S. Stock Investment: In-Depth Understanding of ADR Operation Mechanisms and Investment Tips

Quick Overview of ADR

What is ADR? ADR, or American Depositary Receipt, is issued by U.S. depositary banks on behalf of foreign companies, allowing their stocks to be traded on U.S. stock markets. Investors can directly purchase ADRs on Nasdaq, NYSE, or OTC markets without opening a local account or exchanging currency.

In simple terms, ADR acts as a “stock proxy” issued by foreign companies in the U.S. market, opening a financing channel for foreign firms and providing global investors with a convenient way to invest internationally. However, it is important to note that ADR investments involve liquidity risk, exchange rate risk, and additional costs, which investors should carefully evaluate.

How ADR Works

When foreign companies seek to raise funds in the U.S. securities market, issuing ADRs is a more economical and faster option than direct listing. The company deposits its shares with a U.S. depositary bank, which then issues ADR certificates representing those shares, enabling trading on U.S. exchanges.

For example, TSMC investors do not need to open an account in Taiwan; they can buy its ADR (ticker: TSM.US) directly through U.S. brokers and participate in investment opportunities in this top global chip manufacturer. For the company, this avoids complex U.S. listing procedures; for investors, all trading processes are the same as buying U.S. stocks, greatly lowering the participation barrier.

Classification and Risk Levels of ADR

ADR is divided into two main types:

Sponsored ADR — Officially authorized by the foreign company and issued by a depositary bank. The company is responsible for the ADR issuance and pays fees. These ADRs comply with SEC regulations, regularly disclose financial information, and are generally traded on formal exchanges.

Unsponsored ADR — Issued independently by depositary banks without direct involvement of the foreign company, often traded OTC. Well-known Chinese concept stocks like Tencent (TCEHY.US) and BYD (BYDDY.US) fall into this category, with relatively higher risks.

Based on market access, ADR is further divided into three levels:

Level 1 ADRs have the weakest liquidity and highest risk; Level 2 and 3 ADRs are traded on formal exchanges with stronger regulation.

ADR Ratios: The Hidden Conversion Mechanism

ADR does not correspond 1:1 with foreign stocks but is converted at a certain ratio. For example, TSMC’s ADR ratio is 1:5, meaning 1 ADR represents 5 shares of TSMC stock (stock code 2330); similarly, Hon Hai (HNHAY.US) is also 1:5; Chunghwa Telecom (CHT.US) is 1:10.

The company sets the ratio based on three main factors:

• Foreign stock price levels and exchange rates
• Trading convenience for investors (high stock prices reduce trading activity)
• Liquidity needs

Here is a list of common Taiwanese companies’ ADR ratios:

Domestic Stocks vs ADR: Four Key Differences

Taking Taiwan as an example, the same company’s domestic stock and ADR differ significantly:

Nature and Regulation — Taiwan stocks are actual shares regulated by the Taiwan Stock Exchange; ADRs are certificates representing shares regulated by the SEC, with completely different trading rules and standards.

Trading Venue and Investor Base — Taiwan stocks are traded locally by Taiwanese investors; ADRs are traded on U.S. markets for a global investor base, leading to different supply and demand dynamics.

Codes and Conversion Ratios — Taiwan stock code 2330 (TSMC), ADR code TSM.US; buying one Taiwan stock equals one share, but buying ADR requires considering the ratio (e.g., 1:5).

Price Movement Differences — Although the overall trend is similar, ADRs may trade at a premium or discount relative to the local stock due to exchange rates, liquidity, and investor sentiment. For example, in early 2023, TSMC ADR was trading at over a 3% premium, reflecting strong foreign investor confidence.

Risks and Returns of ADR Investment

Liquidity Considerations

ADR trading volume is often much lower than that of domestic stocks. For example, Chunghwa Telecom’s average monthly ADR volume is only 145,000 shares, compared to 12.24 million shares in Taiwan. Limited liquidity can lead to large bid-ask spreads and difficulty executing trades, especially during market volatility, increasing risk.

Exchange Rate Risk

Since ADRs are traded in USD, non-USD investors must face exchange rate fluctuations. For instance, converting 30,000 TWD into 1,000 USD to buy ADRs and earning a 20% profit would increase holdings to 1,200 USD. However, if the exchange rate depreciates from 1:30 to 1:25, converting back to TWD yields only 30,000 TWD, eroding gains.

Additionally, fluctuations in the exchange rate between the foreign company’s local currency and USD directly impact ADR prices. Investors need to monitor both exchange rates simultaneously.

Premium and Discount Phenomena

ADR prices often deviate from the equivalent foreign stock prices. If the ADR price converted to local currency exceeds the local stock price, it is a premium; if lower, a discount. Savvy arbitrageurs may sell ADRs when at a premium and buy local stocks, or vice versa, to profit.

Company Fundamentals Analysis

Investing in ADRs still involves analyzing the company’s business fundamentals, industry outlook, and policy environment. However, Level 1 ADRs do not have mandatory financial disclosures in the U.S., so investors must obtain financial information from the company’s home market.

Pros and Cons of Investing in ADR

Main Advantages

Lower Tax and Fee Costs — For Taiwanese investors, profits under NT$1 million from ADR trading are tax-exempt; overall tax burden is lighter compared to Taiwan stocks. High-frequency traders often find overseas brokers’ fees for ADRs significantly lower than Taiwan stock trading.

Portfolio Diversification — The U.S. market mainly consists of American companies, but ADRs enable investors to hold both U.S. and international firms. For example, in the EV sector, investors can simultaneously hold Tesla (TSLA.US) and NIO (NIO.US), achieving true global diversification.

Main Risks

Cross-border Operational Costs — Non-U.S. investors need to open overseas brokerage accounts, exchange currency to USD, and handle international remittances, incurring extra costs. Using Taiwanese brokers to purchase ADRs involves 1%-2% commission fees, which can be higher than direct stock trading costs.

Double Exchange Rate Risks — Investors face USD exchange rate risk and the foreign company’s local currency fluctuations against USD, complicating risk management.

Liquidity and Information Asymmetry — ADR liquidity is generally lower than domestic stocks, and foreign companies are less known to U.S. investors, leading to lower participation and increased arbitrage difficulty.

Investment Recommendations Summary

ADR provides a convenient tool for international investors to diversify globally, but it is not a low-risk option. Before investing, assess your risk tolerance, exchange rate sensitivity, and understanding of the target company’s fundamentals. Also, pay attention to the risk levels associated with different ADR grades, avoiding blindly choosing high-risk products. For beginner investors, starting with Level 2 or 3 ADRs (with stricter regulation and better liquidity) is recommended.