Consider These 3 Risks Before Putting Your Money Here
Today we’ll wrap up our ADR (American Depositary Receipts) conversation by looking at the risks associated with them.
Investing of any kind doesn’t come without risk…
So here’s what you need to consider before jumping on the ADR bandwagon:
Risks of Investing in ADRs
Investing in ADRs isn’t without its risks. Here are a few to consider:
1. Political Risk
Obviously, the economy has a different climate in different countries. So don’t count on an ADR stock performing the same as a U.S. investment.
Be sure to do your due diligence. Research the economy and status of the country in question. Is there anything that could alter the financial outlook of the country on the horizon?
Are there sanctions from the U.S., or is there any other developing financial news?
Just as you would look for a catalyst and information about the company for a penny stock trade, you must do the same with ADRs but add into the mix a little research about the country in question.
2. Exchange Rate Risk
While ADRs do a good job of smoothing out the edges of conversions by allowing you to purchase in U.S. dollars, the currency rate still does have an effect on the shares.
The fluctuating value of the dollar and the other currency in question can have an impact on your earnings, as they will need to be converted into U.S. dollars before you receive them.
Be sure to investigate the currency of the home country of the security you’re buying.
If the currency isn’t stable or has low value, this can have an effect on your ADR investment. Even if the company seems to be doing well, this can result in a loss.
While ADRs do help out with the headache of foreign exchange rates and taxes directly when buying, the exchange rate does still matter.
3. Inflation Risk
Along with the exchange rate, remember to be aware of the inflation risk.
Inflation is the rate at which things like services and goods go up in price over time. You know, like your parents talking about how back in their day, a candy bar only cost a penny.
While inflation is natural to a certain degree, if the inflation rate isn’t balanced between the U.S. and the country where the ADRs are from, the investment can lose its value. It’s important to be aware that high inflation can affect your ADR investment.
What Are the Advantages and Disadvantages of ADRs?
Like anything in life, ADRs offer pros and cons for investors. Here’s a breakdown of some of them:
- ADRs offer investors an easy and hassle-free way to buy shares in foreign companies, with reduced admin costs, conversion struggles, language barriers, etc.
- Taxes are simplified with investing in ADRs versus foreign companies directly.
- Usually, the price of ADRs are cheaper than individual shares of stock because of the ADR ratio.
- For the foreign companies, they gain a greater audience in the U.S., which means they can tap into different and more vast markets.
- Foreign companies can help you gain higher returns. Currency fluctuation, the value of the dollar, and even inflation can potentially be used to your advantage.
- Currency conversion fluctuation. The very same inflation and currency fluctuation rates that can help you profit are a double-edged sword and can also result in losses, depending on how the market is going.
- The offerings are limited. Not every foreign company is willing to do the necessary work for sponsorship for to offer ADRs. This means that the offerings are limited for buyers.
- As an investor, you need to hold on to your shares for a long time for good returns.
- Taxing can get tricky. You can be double-taxed on your returns from the IRS and from the issuing country on dividends.
When to Use ADRs
ADRs probably aren’t the first type of investment you’ll tackle when you begin trading.
However, if you’re interested in adding an international element to your investing, it may be worthwhile to explore them as your career advances.
ADRs allow you to make targeted investments — so that you’re investing in particular industries or countries that may be emerging strongly. Given that the stock market is ever-shifting, having some investments overseas may not be such a bad idea.
ADRs aren’t the only option for overseas investing. Look up FOREX trading for another approach to foreign investment, or check out investing in the Asian markets.
Are ADR Fees Tax Deductible?
There’s no easy answer to this.
In the eyes of the IRS, an ADR is treated similarly to a domestic investment, which means you may be subject to dividend taxes and capital gains.
However, this depends on the country in question and what sort of agreement they have with the U.S.
Many ADRs will have dividend payment taxes withheld, which can be upward of 15 to 20%.
You’ll also have to pay income tax on your dividends. Yep: this means double taxing. In some cases, you can claim a deduction for the foreign tax you pay, but once again, this depends on the country.
Be sure to do your research and consult with your broker before investing in ADRs so that you’re not unpleasantly surprised at tax time.
What Are the Differences Between ADR and GDR?
A GDR (Global Depositary Receipt) is a certificate issued by a bank for shares of foreign companies, which trade as domestic shares. It is a way of raising capital, primarily in the U.S. and European markets.
Per Investopedia, “A GDR a financial tool that is used by private markets to raise capital that is denominated in either American dollars or euros. They are called European depositary receipts when private markets are trying to get euros.”
Wait, sounds a lot like an ADR, right? So what’s the difference?
The Process of Issuing ADR and GDR
While GDRs are similar to ADRs, there’s an important difference. GDRs let the issuer raise funds in multiple markets simultaneously. This allows them greater exposure.
According to ADR.com, “The GDR is generally structured as a combination of a Rule 144A ADR, which trades in the U.S. private placement market, and a public offering outside the United States under Regulation S.”
Difference Between Depositary Receipt vs. Common Stock
Just because ADRs can be purchased on the same exchange and are treated similarly to stocks doesn’t mean they’re the same as common stock.
Securities laws keep foreign companies with listings on foreign exchanges to list their shares on the U.S. exchange concurrently.
If a foreign company wants its shares to be available in U.S. dollars on the U.S. exchanges, ADRs are the way to do it.
If you’re interested in adding a global dimension to your portfolio but don’t know where to begin, ADRs may be worth considering.
ADRs offer the opportunity to invest overseas with minimal confusion and hassle, and can help you benefit from the financial success of other regions of the world.
— Tim Sykes
Editor, Penny Stock Millionaires