Introduction to U.S. Stock Investment: Mastering the Core Knowledge and Risk Points of ADRs

The Basics of ADR You Need to Know First

ADR (American Depositary Receipt) is another form of presence for foreign companies in the U.S. capital markets. Simply put, when overseas enterprises want to enter the U.S. stock market, they deposit their shares with a U.S. depositary bank, which issues receipts representing those shares. Investors can then buy these receipts just like trading U.S. stocks on NASDAQ, NYSE, or OTC markets.

For example, Taiwan’s TSMC is listed on the Taiwan Stock Exchange (ticker 2330) and also issues ADRs on the New York Stock Exchange (ticker TSM), allowing U.S. and global investors to trade directly. For investors, ADR can be simply understood as stocks issued by foreign companies in the U.S. stock market, with trading methods similar to U.S. stocks.

Why Do Foreign Companies Issue ADRs?

For issuing companies, ADRs provide a relatively easy financing route. Compared to the cumbersome procedures and high costs of directly listing in the U.S., issuing ADRs is more straightforward and cost-effective. Many companies already listed domestically prefer not to go for a secondary listing, but since the U.S. stock market is one of the largest and most active capital markets globally, issuing ADRs becomes the best way to access U.S. financing.

For investors, if they want to buy shares of a foreign company that hasn’t issued ADRs, the process can be quite complicated—requiring opening foreign brokerage accounts, currency exchange, and bearing exchange rate risks. With ADRs, investors can operate normally within their U.S. stock accounts, greatly simplifying the process.

Two Types of ADR Issuance and Three Risk Levels

Depending on the issuer, ADRs are divided into Sponsored and Unsponsored types:

Sponsored ADRs: Issued by a bank on behalf of the foreign company under a formal agreement. The company retains control over the ADRs and pays fees to the bank, which handles trading. These ADRs typically comply with SEC regulations, disclose financial information periodically, and are well-regulated.

Unsponsored ADRs: May not be directly authorized by the foreign company and are operated solely by the depositary bank. These ADRs can only be traded over-the-counter (OTC), with higher risks. Tencent (TCEHY.US), BYD (BYDDY.US), and Meituan (MPNGY.US) are examples of unsponsored ADRs.

ADRs are also categorized into three levels based on their entry into the U.S. market, each with different regulatory requirements and liquidity:

Level 1 ADRs are the riskiest because of minimal disclosure and lowest liquidity; Levels 2 and 3 are listed on mainstream exchanges, offering better liquidity and compliance.

ADR Ratios: 1:1 Is Not a Universal Standard

Investors need to understand an important concept: the ADR-to-foreign stock conversion ratio is not always 1:1. For example, Hon Hai’s ADR ratio is 1:5, meaning 5 shares of Taiwan Hon Hai (2317.TW) equal 1 ADR (HNHAY.US).

Companies usually set ratios based on stock prices and exchange rates. If the stock price is too high, affecting liquidity, they will adjust the ratio to make the stock more affordable. Here are the main Taiwan companies’ ADR ratios:

ADR vs Domestic Stocks: Six Major Differences You Must Know

Although ADRs and domestic stocks of the same company may look similar, there are fundamental differences:

Nature: Domestic stocks are shares of the company; ADRs are depositary receipts representing those shares.

Trading Venue: TSMC trades on the Taiwan Stock Exchange under Taiwan regulations; ADRs are traded in the U.S. under SEC rules.

Stock Ticker: Different due to issuing location and exchange (e.g., Hon Hai’s Taiwan stock code 2317, ADR code HNHAY).

Investor Base: Domestic stocks mainly target local investors; ADRs are aimed at global investors.

Conversion Ratio: Buying Taiwan stocks is usually 1:1; buying ADRs follows the preset ratio (e.g., TSMC 1:5).

Premium/Discount Phenomenon: Although trends are similar, due to market factors, time zone differences, and investor preferences, ADRs and domestic stocks may show divergence in daily candlestick patterns and returns. For example, TSMC ADR’s performance from January to March 2023 differed from the Taiwan stock, illustrating the premium/discount effect.

A-Share ADRs Follow Similar Logic

Like Taiwan ADRs, A-shares also have ADR versions. BYD and Great Wall Motors are traded on Shanghai and Shenzhen exchanges and also listed as ADRs in the U.S. (BYDDY, GWLLY), targeting Chinese and overseas investors respectively.

Three Major Risks You Must Assess Before Investing in ADRs

Liquidity Risk Cannot Be Ignored

Foreign companies often have lower recognition overseas than domestically, resulting in fewer investors trading their ADRs. Additionally, the issuance volume of ADRs is less than that of ordinary stocks. For example, China Telecom (CHT.US) had an average daily trading volume of only 145,000 shares in March, far below the 12.24 million shares traded daily on the Taiwan Stock Exchange during the same period. Poor liquidity can affect bid-ask spreads and trading speed.

Exchange Rate Fluctuation Brings Hidden Costs

Investing in ADRs requires trading in USD, exposing investors to exchange rate risks. Suppose an investor exchanges 30,000 TWD to buy ADRs at an exchange rate of 1:30, equivalent to $1,000. If the ADR rises 20% to $1,200, but the exchange rate shifts to 1:25 when converting back, they only get 30,000 TWD—meaning gains are offset by currency risk. If the company’s local currency fluctuates significantly against USD, the ADR will also fluctuate accordingly.

Company Fundamentals and Premium/Discount Judgement

Like any stock investment, investing in ADRs requires evaluating the company’s management quality, industry outlook, policy support, etc. For example, TSMC’s ADR surged 32% in early January 2023, driven by China’s reopening, strong earnings reports, and industry optimism.

Note that Level 1 ADRs in the U.S. are not required to disclose financial reports; investors must track disclosures in the company’s home market themselves.

Another key indicator is the ADR premium or discount. TSMC’s ADR ratio is 1:5. If on March 22, 2023, the ADR closed at $92.6, the equivalent in TWD is (92.6 ÷ 5) × 30 = 553.3 TWD, while the Taiwan stock closed at 533 TWD. This indicates an ADR premium. Experienced investors may sell when ADRs are at a premium and buy when at a discount to arbitrage.

Pros and Cons of Investing in ADRs

Advantages of ADRs

Tax and fee benefits: For Taiwanese investors, profits under 1 million TWD from ADR trading are tax-free, and no transaction tax applies. Trading ADRs through overseas brokers incurs much lower fees than Taiwan brokers (sometimes zero), giving cost advantages for frequent traders.

Diversification opportunities: Through ADRs, U.S. investors are no longer limited to U.S. companies. For example, they can hold both Tesla (TSLA.US) and NIO (NIO.US) to gain broader exposure to the electric vehicle industry.

Disadvantages of ADRs

Operational complexity for non-U.S. investors: Taiwanese investors need to open overseas brokerage accounts, perform currency exchange, and deposit USD, incurring exchange costs. Using Taiwanese brokers for proxy purchases can involve fees of 1-2%, much higher than overseas brokers.

Multiple risks stacking: Investors must judge not only the company’s stock price trend but also face exchange rate fluctuations, liquidity differences, time zone delays, and other risks, increasing decision complexity.

Summary

ADRs open a broader investment horizon for global investors, but they are not risk-free arbitrage tools. Successful ADR investment hinges on understanding the classification and risk levels, mastering ratio conversions, continuously monitoring company fundamentals, paying attention to exchange rates and premium/discount changes, and assessing personal risk tolerance. For newcomers to U.S. stocks, starting with high-liquidity Level 2 or 3 ADRs, carefully evaluating before adding to their portfolio, is the wise approach.