Going Global: Selecting ADRs or Foreign Stocks

February 25, 2011

John Wightkin
Director of Equity Research Applications, Schwab Center for Financial Research

Let's say you've decided to invest in a stock. If you've chosen a US stock, your next step might be to place a trade. But if it's a foreign stock, you have another decision to make. Should you buy an American Depositary Receipt (ADR), a foreign stock listed in the US over-the-counter (OTC) market, or a foreign stock on the local foreign exchange?

Indeed, stocks in the same foreign company can often be traded in multiple ways. For example, Toyota, the auto manufacturer, is available as an ADR, a foreign stock (also known as an "ordinary") in the US OTC market, and a foreign ordinary on the Tokyo Stock Exchange in Japan, where the company is listed.

Given this fact, you'll want to consider the available alternatives and select the one that's right for you.

To help you decide, we'll look at:

• What are the options for investing in individual foreign stocks?
• What factors should I consider?
• How to get started.

Source: The Schwab Center for Financial Research.

What are the options?

If you're looking to invest in individual foreign stocks, you could potentially have three ways to invest.

• ADRs are stocks that trade in the United States but represent a specified number of shares in a foreign company. ADRs are bought and sold on US exchanges—including the Nasdaq, New York, and American stock exchanges, and in the US OTC market—just like regular stocks. They are issued in the United States by a bank or brokerage firm which holds shares of the foreign ordinary in a trust, and then issues receipts (the ADRs) backed by one or more (or more rarely, fewer) shares of the foreign ordinary. ADRs are denominated in US dollars. The value of an ADR rises and falls based on the price of the company's shares traded in their home country. Typically, ADRs represent the shares of large-cap companies from developed markets.
• Foreign ordinaries (local exchange traded) are stocks of foreign companies that are traded directly on a foreign stock exchange. Orders are sent from a US broker to local brokers in foreign markets and executed during local market hours. Orders placed after a foreign exchange is closed will be placed in a queue and executed when the market opens. All foreign trades are quoted and settled in US dollars. However, changes in the value of the underlying currency in which your stock is held can impact your investment returns.
• Foreign ordinaries (OTC) are stocks of foreign companies that are traded on the US OTC market. The OTC market is a computer- and telephone-based system. Any stock that does not trade on Nasdaq or a national securities exchange like the New York Stock Exchange can trade over the counter. A number of competing broker-dealers, also called market makers, negotiate directly with each other to price OTC stocks. Because of the cumbersome reporting requirements and expense of listing on registered exchanges, the OTC market has become an attractive platform for international companies to offer their securities in the United States. Trades, although reported in US dollars, include the potential for gain or loss from foreign currency fluctuations.

What factors should you consider?

As you weigh the available individual foreign stock investments, here are some factors to consider:

• Liquidity. If you invest in foreign ordinaries through a local exchange, there is more liquidity than in the OTC market or through ADRs. As a result, trades will often execute at a better price.
• Position size. There's a $5,000 minimum required at Schwab to buy foreign ordinaries on a local exchange. If your order is less than this amount, you will need to obtain the stock either in the US OTC market or as an ADR.
• Information. Listed ADRs—those registered with the SEC and subject to US accounting rules—must file quarterly results, so there may be more investor information available than with a foreign ordinary (both OTC and local market). Please note that unlisted ADRs that trade in the US OTC market have minimal reporting requirements, so information may be less complete and harder to obtain.
• Fees. There are additional costs associated with investing in a foreign ordinary (both OTC and local market). These fees can include exchange fees, stamp duties, transaction levies and foreign currency fees. Trading and currency conversion fees will be included in your execution price. For more information on fees, see the Schwab Pricing Guide. Also note that banks that issue ADRs charge annual custody fees. The amount and timing of custody fees are detailed in the ADR's prospectus. On the whole, ADRs are an easier and more cost effective way to buy shares in a foreign company. They save money by reducing administration costs and avoiding foreign taxes on each transaction.
• Market hours. Trades on foreign exchanges are executed during local market hours, which are typically not during US market hours. If you place a trade outside local market hours, your order will be queued up and executed on the foreign exchange at market open.
• Restrictions. Some countries impose controls that restrict or delay currency conversions on foreign ordinaries, prolonging the time you have to wait until you're able to access your funds. Reporting, clearing and settlement of trades may also take longer. In addition, some countries may place round-lot and/or minimum-lot restrictions on trades made on their exchanges.
• Limited availability. Companies that offer ADRs tend to be concentrated in specific countries, and usually only larger firms offer ADRs. Purchasing only ADRs can make it difficult to build a diversified portfolio. In addition, while the foreign ordinary OTC market is growing, it's still limited, and concentrated in large-cap stocks.

Bottom line

Depending on the circumstances, any of the three options may be suitable at a given time. But here are some final thoughts:

• ADRs. If an ADR is available for a given stock, you may want to consider it if you prefer lower trading costs and want to trade online. ADRs usually have decent liquidity and are suitable for investors who want smaller positions. And unlike foreign ordinary shares, most listed ADRs are marginable.
• Foreign ordinary (OTC). Given the $5,000 minimum required to place trades on a foreign market, another potential alternative for smaller positions are foreign ordinary shares traded on the US OTC market, should they be available. The commission and associated fees are higher than those for ADRs, and the liquidity may not be nearly as strong. But if there isn't an ADR available, the trade amount is for less than $5,000, and you want to place the trade during US market hours, then this may an appropriate way to go.
• Foreign ordinary (local market). For orders greater than $5,000, local foreign exchanges are often the best alternative, due to their superior liquidity and costs, once the higher trade amount is factored in. Given the much greater liquidity available in these markets, investors are more likely to get a better quote than they would for a similar trade on the OTC market. However, these orders are executed during the local market hours, which may not always be convenient for US investors.

Questions?

If you have a question or topic about international investing that you'd like to see addressed in a future article, send it via the Editor Feedback box on the right-hand side of the page.

1. Liquidity refers to the ability to quickly buy or sell an asset without affecting the asset's price in a significant manner, not the ability to receive cash quickly.
2. Foreign market hours vary. Broker-assisted order placement hours are different from order execution.
3. Most ADRs listed on US stock exchanges are marginable. ADRs that are traded through the US OTC market are not marginable.