Understand the true meaning of ADR in one article | A must-know for US stock investment beginners

What exactly is an ADR, and why are so many Taiwanese investors paying close attention? Simply put, ADR stands for American Depositary Receipt, a special financial instrument representing foreign stocks. If you want to invest in international companies like TSMC or BYD on the US stock market, ADR is an unavoidable concept.

How does ADR work? A simple diagram explains the logic instantly

Foreign companies seeking financing in the US have two options: either list directly on the NYSE or NASDAQ, or issue ADRs. Compared to the complex procedures and high costs of full listing, ADR offers a more streamlined solution.

The specific process is as follows: foreign companies deposit their shares with a US depositary bank, which then issues corresponding ADR certificates. This allows investors to trade directly on NASDAQ, NYSE, or OTC markets. In simple terms, an ADR is like a stock issued by a foreign company on the US stock market, with almost the same trading experience.

Taking TSMC as an example, you can choose to buy 2330 (Taiwan stock code) in Taiwan or TSM (ADR code) in the US. They are the same company behind the scenes, but the trading locations, regulations, and even stock price trends may have slight differences.

There are two types of ADRs, with significantly different risk levels

Sponsored ADRs are issued under the guidance of the foreign company, with banks signing agreements with the company. These ADRs must comply with strict requirements from the US Securities and Exchange Commission (SEC), including regular financial disclosures. Well-known companies like TSMC and Hon Hai mostly fall into this category, with good liquidity and relatively manageable risks.

Unsponsored ADRs are not directly involved with the company; instead, banks operate them independently. Tencent(TCEHY.US) and BYD(BYDDY.US) are typical examples. These ADRs can only be traded OTC, with less information disclosure, weaker liquidity, and higher risks compared to sponsored ADRs.

Besides categories, ADRs are also divided into three levels:

• Level 1 ADRs: Lowest threshold, traded OTC, minimal disclosure, highest risk
• Level 2 ADRs: Traded on main exchanges (NASDAQ, NYSE), more regulated
• Level 3 ADRs: Highest level, can be traded and used for fundraising, most stringent compliance

What do 1:5 and 1:10 mean? Clarify the conversion ratio

This is a common pitfall for beginners. The conversion ratio between ADR and the parent company’s stock is not 1:1.

For example, TSMC’s ADR ratio is 1:5, meaning 5 shares of Taiwanese TSMC stock equal 1 ADR share in the US. Hon Hai is 1:5, Chunghwa Telecom is 1:10. Why do ratios differ? Mainly depending on the parent stock’s price, USD exchange rate, and whether the company wants the ADR’s trading price in the US to be investor-friendly.

A high stock price reduces liquidity, so companies adjust the ratio to make ADR prices more accessible. That’s why the same Taiwanese company can have different conversion ratios.

Why do Taiwan stocks and Taiwan ADRs sometimes move differently?

Although both are Taiwanese companies, the Taiwan stock market and ADRs often show divergent trends, even exhibiting “premium” or “discount” phenomena.

Premium means the ADR price, converted, exceeds the parent stock price, indicating US investors are more optimistic about the company; discount is the opposite. For example, in March 2023, TSMC’s ADR premium was about 3.8%, meaning US investors are willing to pay a higher price.

This difference stems from multiple factors: exchange rate fluctuations, trading volume disparities, different investor groups, incomplete information synchronization, etc. Experienced investors may exploit these premiums and discounts for arbitrage, but for beginners, understanding that this difference itself contains risks is key.

Before investing in ADRs, these three risk points must be considered

Lack of liquidity is the biggest risk. Take Chunghwa Telecom(CHT.US) as an example: the average monthly trading volume of its US ADR is only 145,000 shares, while the Taiwan stock’s average is as high as 12.24 million shares—an enormous gap. Low trading volume means difficulty buying or selling, wider spreads, and increased risk of being caught in volatile markets.

Exchange rate risk is the second major hidden danger. Suppose you exchange 30,000 TWD for 1,000 USD to invest in ADRs, and earn a 20% profit, making your assets worth 1,200 USD. But if the USD/TWD exchange rate drops from 1:30 to 1:25, converting back only yields 30,000 TWD. You made a profit in USD terms, but due to exchange rate decline, your actual return is zero.

Company fundamentals lack transparency is the third issue. Especially for Level 1 ADRs, which are not required to disclose financial reports regularly in the US, making it hard for investors to understand the company’s operational status in time. You then need to actively seek information from the parent country, which can be costly and time-consuming for busy investors.

The practical pros and cons of investing in ADRs

Advantages: For Taiwanese investors, profits from ADRs under 1 million TWD are tax-free, and there are no stock transaction taxes. If trading frequently, overseas brokers often charge lower fees( or even zero fees), much lower than Taiwan’s costs. Additionally, ADRs open a global investment horizon—you can invest in Tesla listed in the US or NIO in China, achieving true diversification.

Disadvantages: Non-US investors face complicated procedures. Opening an overseas brokerage account, currency exchange, and fund transfers all incur costs. Using Taiwanese brokers to buy ADRs involves fees of 1%-2%. Moreover, exchange rate fluctuations, poor liquidity, and information delays are costs long-term investors must bear.

Summary

ADR, simply put, is a foreign stock certificate traded on the US stock market. It provides international companies with a low-cost US financing channel and offers global investors diversified options. But investing in ADRs is not risk-free—liquidity, exchange rate, and information asymmetry are three major hurdles that cannot be ignored. Beginners should first understand their specific risk tolerance before deciding whether to allocate assets to ADRs.