ADRs: Once a Gateway to Foreign Investments, Now a Potential Minefield
American Depositary Receipts (ADRs) have long been a popular way for U.S. investors to buy foreign companies in the U.S. However, U.S. sanctions have made ADRs much riskier than they used to be.
American Depositary Receipts (ADRs) have long been a popular way for U.S. investors to buy shares of foreign companies in the US. However, the increased and unpredictable use of U.S. sanctions has increased the risks associated with ADRs, making this investment strategy more dangerous than it once was.
ADRs Unveiled: The Wall Street Shortcut to Owning Foreign Stocks
Before we discuss the new dangers, let's review what ADRs are. American Depositary Receipts, or ADRs, are a way for U.S. investors to buy and sell shares of foreign companies on U.S. stock exchanges. Here's how they work:
Creation: A U.S. bank buys a large number of shares of a foreign company on its home stock exchange. For example, it buys a large number of shares of LG (a large South Korean company) on the South Korean stock exchange.
Conversion: The bank then creates ADRs representing those foreign shares. An ADR can represent one share, several shares, or even a fraction of a share.
Trading: These ADRs are then listed on U.S. exchanges, such as the New York Stock Exchange or NASDAQ.
Buying and selling: U.S. investors can buy and sell these ADRs just like any other U.S. stock, using U.S. dollars.
Benefits: ADRs make it easier for U.S. investors to invest in foreign companies without having to deal with foreign currencies or unfamiliar stock exchanges, and without the foreign account reporting requirements (FBAR, FATCA).
In essence, ADRs act as a bridge between U.S. investors and foreign companies, making global investing more accessible to Americans.
They allow U.S. investors to add international companies to their investment portfolios without leaving the familiar U.S. stock market. In short, ADRs used to offer Americans the best of both worlds. But not anymore.
Stock Market Essentials: Primary Market, Secondary Market, and Why Investors Should Care
The distinction between the primary equity market and the secondary equity market is important because the increased use of U.S. sanctions has impacted not only the primary equity market (hurting the foreign company or country), but also the secondary equity market (hurting U.S. ADR investors).
The primary market is where new shares are created. When a company decides to sell shares for the first time, or wants to issue more shares to raise money, it does so in the primary market. This is a big deal for companies because they get money directly from investors who buy these new shares. This doesn't happen very often - usually only when a company is going public for the first time (called an IPO) or needs to raise more money for growth.
The secondary market, on the other hand, is where most of the day-to-day action takes place. This is where investors buy and sell existing shares to each other. It's like a busy marketplace where shares change hands all day long. The key difference is that when you buy a share on the secondary market, your money doesn't go to the company. Instead, it goes to another investor who's selling his or her shares. The company doesn't make any money on these trades. For example, if you log into your brokerage account and buy shares of Apple, you're participating in the secondary market. The money you spend goes to the person selling those Apple shares, not to Apple. It's like buying a used car - your payment goes to the previous owner, not the car manufacturer.
Understanding this difference helps explain why companies don't get funding from the secondary market. They have already received their funding from the primary market. The secondary market, while important to investors, is essentially a place to trade ownership of existing shares.
Watch Out! Why ADRs Aren't as Safe as They Used to Be
In recent years, the U.S. has increasingly used sanctions as a tool of foreign policy, creating new risks for investors. Ironically, many of these sanctions impact the secondary equity market in the United States. This mainly hurts U.S. investors, and not really the targeted foreign company or country. Either way, this is now the new reality, and these new political risks have made ADR investing more challenging.
For example, this very situation occurred in 2022. Russian ADRs trading on U.S. exchanges were suddenly delisted due to U.S. sanctions. This meant that American investors who owned these stocks couldn't sell them or access their money. Many people lost a lot of money, even though these Russian stocks had been available in the U.S. for decades.
The sudden inability to trade or access these investments caught many investors off guard. The problem was further complicated by new Russian laws that required the termination of ADR programs in response to U.S. sanctions , making it even more challenging for U.S. investors to recover their investments. There were further complications, but they are beyond the scope of this article.
Similar risks could arise with ADRs of other countries with strained relations with the U.S., such as China. In addition, countries in the rapidly growing BRICS+ group, and random countries and companies around the world (under the secondary sanctions approach) could also be high-risk candidates for sanctions.
Foreign Investments in a Changing World: What You Need to Know
It is still prudent to diversify one's investment portfolio and include international investments, but it has become more challenging and requires a more nuanced strategy. While ADRs (American Depositary Receipts) remain a viable way to invest in foreign companies, one must now consider the increased political risks.
Increased risks: U.S. sanctions may affect ADRs, making them less attractive. Therefore, the benefits must be carefully weighed against these risks.
Due Diligence: It's important to thoroughly research and evaluate the risks before investing in ADRs, especially in today's volatile geopolitical climate.
Stable Countries: ADRs from countries with stable relations with the U.S., such as the EU or Japan, are less likely to face sanctions-related issues. However, it's important to monitor these relationships, as they can change over time.
In addition to ADRs, U.S. investors have other options for investing in foreign markets, including
Exchange-traded funds (ETFs) and mutual-funds: International funds can give you access to global markets and are often less risky than individual ADRs if they invest directly in local stocks or are diversified across many countries and companies. However, if they invest in ADRs or are concentrated in specific regions, they carry similar risks to ADRs. Additionally, the quality of the fund's management is crucial. Poorly managed funds may not take the necessary steps to protect investors during sanctions, increasing the risk.
U.S. Companies with Large Foreign Operations: Another way to invest in foreign markets without buying international stocks directly is to buy U.S. companies that do a lot of business overseas. In this way, it is possible to gain exposure to global markets through familiar U.S. companies. Well-known companies such as Coca-Cola, Walmart, Colgate-Palmolive, Apple, and others generate a significant portion of their revenue in foreign countries. This requires some homework, but can be a good indirect way to invest in foreign markets.
Direct foreign market trading: Some U.S. brokers allow investors to trade directly on international exchanges. This approach may involve higher fees and more paperwork.
Direct foreign investing: Investors can open an account with a local broker in the target country. However, this option is only appropriate for highly sophisticated and proactive investors due to the additional costs, complex reporting, and regulatory requirements (such as FACTA and FBAR)
Summary
While global investment diversification remains a sound strategy, it now requires more careful planning and monitoring due to the heightened political risks associated with ADRs. A more thoughtful and strategic approach to navigating international investments is critical.
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Disclaimer
Neither the author nor Fringe Finance is a financial advisor. This article is for illustrative and educational purposes only and does not constitute a specific offer of any product or service.
Past performance of stocks and assets is not an indicator or guarantee of future performance of stocks and assets.
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