Must-read before investing in US stocks: In-depth analysis of ADR operation mechanisms and investment risks

Do You Really Understand ADR? Starting from Actual Investment

Many Taiwanese investors want to enter the US stock market but face a problem: how to conveniently invest in foreign companies? The answer is ADR (American Depositary Receipt). But before starting to invest, you must first understand the essence of ADR, how it works, and the hidden risks involved.

Understanding ADR: A Bridge for Foreign Companies Entering the US Stock Market

ADR stands for American Depositary Receipt, a certificate issued by US depositary banks representing foreign stocks. Simply put, when companies from Taiwan, China, or other countries want to trade on the US stock market, they deposit their shares with a US depositary bank, which then issues ADR securities. This allows foreign investors to buy these foreign company stocks directly on NASDAQ, NYSE, or OTC markets, just like purchasing regular US stocks.

For example, Taiwan’s semiconductor giant TSMC (TSM.US) entered the US stock market by issuing ADRs. For investors, ADR can be simply understood as an agent stock issued by a foreign company in the US, with trading methods identical to ordinary US stocks.

Why Are Foreign Companies Choosing to Issue ADRs?

For foreign companies, compared to directly listing in the US, issuing ADRs is simpler and less costly. Many companies like TSMC, Hon Hai (HNHAY.US), and others are already listed in their home countries and do not want to undergo a secondary listing but still wish to raise funds in the US market. ADR provides a relatively easy solution.

The benefits for investors are also obvious. Imagine trying to buy shares of a foreign company without ADRs—this process would be complicated: opening a foreign securities account, currency exchange, bearing exchange rate risks, learning local trading rules. With ADRs, everything becomes as simple as buying other US stocks—just operate in US dollars.

Classification and Grade Differences of ADRs

Another key point before investing in ADRs is: Not all ADRs are equal.

ADR types are divided into two categories:

Sponsored ADRs issued by a bank on behalf of a foreign company. The company signs an agreement with the bank, maintains control over the ADR, and pays issuance fees. These ADRs must comply with SEC regulations, disclose financial information regularly, and carry relatively lower risks.

Unsponsored ADRs may have no involvement from the foreign company at all, only implemented by the depositary bank. These ADRs can only be traded over-the-counter (OTC), and are riskier. Tencent (TCEHY.US), BYD (BYDDY.US), Meituan (MPNGY.US) are examples of unsponsored ADRs.

In addition to types, ADRs are also divided into three levels based on their entry into the US market:

Level 1 ADRs carry the highest risk because they are the least regulated, with minimal disclosure and lowest liquidity. Levels 2 and 3 are listed on formal exchanges, thus relatively safer.

ADR Ratios: Understanding the Conversion Secrets

This is a common oversight among beginners: ADR and foreign stocks are not 1:1 equivalents.

For example, Hon Hai’s ADR ratio is 1:5, meaning 5 shares of Taiwan Hon Hai (2317.TW) equal 1 ADR (HNHPF.US). TSMC’s ratio is also 1:5, but Chunghwa Telecom (CHT.US) has a ratio of 1:10.

The logic behind setting these ratios mainly considers: the stock price levels abroad, current exchange rates, and liquidity considerations. If the stock price is too high for easy trading, the company will adjust the ratio to optimize liquidity.

Here are the main Taiwan companies’ ADR ratios for reference:

Differences Between Taiwan Stocks and ADRs: Five Key Points Investors Must Understand

Although TSMC (TSM.US) is listed both in Taiwan and the US, there are fundamental differences between Taiwan stocks and Taiwan ADRs.

Nature Difference: Taiwan stocks are actual issued shares of the company, while ADRs are depositary receipts representing shares; their essence differs.

Regulatory Difference: Taiwan stocks are regulated by the Taiwan Stock Exchange and Taiwanese authorities, whereas ADRs are regulated by the SEC in the US.

Trading Venue: Taiwan stocks are traded through the Taiwan Securities Exchange, while ADRs are traded on NYSE, NASDAQ, or OTC.

Ticker Difference: The same company has different tickers in different markets. For example, Hon Hai’s Taiwan stock code is 2317, while its US ADR code is HNHAY.

Investor Base: Taiwan stocks mainly target Taiwanese investors, while ADRs attract a global investor base.

Premium and Discount Phenomenon: Hidden Arbitrage Opportunities

The trends of Taiwan stocks and Taiwan ADRs are generally similar but not perfectly synchronized. This creates premium and discount phenomena.

For example: On March 22, 2023, TSMC ADR closed at $92.6. Using a 1:5 ratio and the exchange rate of 1:30, it converts to NT$553.3, while the same day’s Taiwan stock closed at NT$533. Therefore, the ADR is at a premium.

Premium indicates that the ADR’s converted price is higher than the Taiwan stock price, suggesting that overseas investors are more optimistic about the company. Discount is the opposite. Some advanced investors exploit arbitrage by selling ADRs when they are at a premium and buying Taiwan stocks, or vice versa.

The Difference Between A-shares and A-shares ADRs

The same logic applies to the A-share market. A-shares are Chinese stocks traded on the Shenzhen or Shanghai exchanges, while A-shares ADRs are proxy stocks of Chinese companies traded on US markets.

Three Core Considerations Before Investing in ADRs

Liquidity Risk Cannot Be Ignored

The most overlooked risk in ADR investment is liquidity. Foreign companies are usually less known overseas than domestically, and fewer investors are willing to trade their ADRs. Plus, the issuance volume of ADRs is much lower than ordinary stocks, making buy-sell spreads potentially wide.

For example, China Telecom (CHT.US) had an average trading volume of about 145,000 shares in March, while its Taiwan stock’s daily trading volume was 12.24 million shares—only about 1.2% of the Taiwan stock volume. This means large transactions could face liquidity difficulties.

Company Fundamentals Determine Long-term Performance

Investing in ADRs is no different from investing in any stock; in-depth research on the company’s fundamentals is essential. Management, industry outlook, policy environment—all influence the long-term performance of ADRs.

Note that Level 1 ADRs in the US do not require financial disclosures. Investors must proactively review the company’s financial information in its original issuing country. For example, TSMC’s ADR surged 32% in early January 2023, mainly driven by China’s easing of pandemic restrictions, strong financial reports, and bright industry prospects.

Exchange Rate Risk Is a Double-Edged Sword

Investing in ADRs requires trading in US dollars, which automatically introduces exchange rate risk. Suppose you invest NT$30,000 to buy ADRs at an exchange rate of 1:30, getting $1,000. If your investment gains 20%, your assets become $1,200, but if the exchange rate shifts to 1:25, converting back to NT$, you only get NT$30,000—the investment profit is completely offset by the exchange rate fluctuation.

Furthermore, if the foreign company’s local currency fluctuates sharply against the dollar, ADRs will also be affected. Investors need to consider both stock price volatility and exchange rate fluctuations simultaneously.

Comprehensive Evaluation of the Advantages and Disadvantages of ADR Investment

Advantages of ADR Investment

Tax Cost Benefits: Taiwanese investors profit from ADR trading without paying income tax on gains under NT$1 million. Compared to the transaction tax on Taiwan stocks, ADRs have a lighter tax burden.

Lower Fees: Many overseas brokers offer zero-commission trading, while Taiwan stock trading fees are relatively high. Frequent traders may find ADRs more cost-effective.

Portfolio Diversification: Through ADRs, investors can access companies from different countries worldwide. Want diversified exposure in electric vehicles? Invest in US Tesla (TSLA.US) and Chinese NIO (NIO.US), greatly expanding options.

Disadvantages of ADR Investment

Relatively Complex Account Opening: Non-US investors need to open overseas brokerage accounts, perform currency exchange, and deposit US dollars—these upfront costs are significant. Using Taiwanese brokers to buy ADRs incurs a fee of 1%-2%, which is quite high.

Persistent Exchange Rate Risks: As mentioned, fluctuations in USD/TWD directly impact final returns. This systemic risk must be borne by ADR investors.