cross-currency investing: adr and foreign ordinary shares

In short

A friend of mine bought shares of a Dutch company through his regular brokerage account and thought it would be as easy as buying a share of Ford. It nearly was. An ADR, short for American depositary receipt, is a certificate that trades in dollars on a U.S. exchange and stands for shares of a company based overseas. A foreign ordinary share is the real thing, bought on the home market in the home currency. If you are weighing the two, start by asking what currency you want to be paid in and what you can stand to pay in fees. Check the ADR program's fee page, because the depositary bank may charge a small yearly fee per share. Look at whether the company is sponsored, since that tells you who is behind the receipt. Read your broker's fee schedule for foreign trades. And remember that either way, a falling foreign currency can shrink your return even when the stock holds steady.

The whole of it

What it is

I once watched a man at a county fair swap his dollars for tickets, and then spend the tickets on pie. The money was one thing and the pie was another, but the tickets made the trade easy. An ADR works a good deal like that ticket. A U.S. bank, called the depositary, holds a pile of shares of a foreign company in that company's home country. The bank then issues receipts against that pile, and the receipts trade in U.S. dollars on an American exchange or over the counter. Each receipt stands for some number of the real shares. It might be one share, half a share, or ten shares. That number is the ratio, and it is set when the program is created.

A foreign ordinary share is simpler to describe and harder to buy. It is the plain common stock of the company, listed on its home exchange and priced in the home currency. A Japanese company's ordinary shares trade in yen. A Swiss company's trade in francs. To own them directly, your broker must offer access to that market, and the trade often involves a currency exchange along the way.

Both give you a piece of the same business. The difference lies in the plumbing. That plumbing decides your costs, your tax paperwork, and how the currency touches your money.

How it works

If you are holding an ADR, you probably bought it the way you buy any U.S. stock. You placed an order in dollars, and it settled in dollars. The depositary bank handles the rest behind the curtain. When the company pays a dividend, it pays in its home currency. The depositary converts that money to dollars and passes it along, usually after taking a small fee. That fee is set out in the program's own documents, so it pays to look.

ADRs come in two broad kinds. A sponsored ADR is set up with the company's cooperation, and the company has signed an agreement with the depositary. An unsponsored ADR is set up by a bank without the company's formal involvement. The SEC explains these differences in its investor materials on ADRs. Sponsored programs tend to come with clearer reporting. That is worth knowing, though not a promise of quality.

Direct ordinary shares work differently. Your broker must route your order to a foreign exchange. Your dollars must be turned into the local currency first, and the broker sets the exchange rate it uses. Some brokers add a markup to that rate. Others charge a flat fee. The market may also keep different hours than yours, so an order placed at breakfast may wait until the foreign market opens.

Then there is the foreign tax. Many countries hold back part of a dividend before it ever reaches you. A U.S. investor can often claim a credit for that tax on a U.S. return, using IRS Form 1116, though the rules have limits. The IRS explains this in Publication 514, Foreign Tax Credit for Individuals. A tax professional can say how it fits your own case. Some ADRs also pass along a foreign tax charge through the depositary, so it shows up on your tax form either way.

The numbers, and where to find yours

Plain numbers matter here, and most of them sit on pages you can read for free. The ADR ratio, the depositary bank, and the program fee are listed in the depositary's own program page. J.P. Morgan, BNY Mellon, and Citibank each run a public directory of their ADR programs. The yearly custody fee is often a few cents per share, but the exact figure is on the program's page, so go there instead of guessing.

Your broker's cost for foreign trades is in its published fee schedule. Look for the commission on international orders and the foreign exchange markup. These two lines can differ a lot from one broker to the next.

The withholding rate on dividends depends on the company's home country and on any tax treaty with the United States. The IRS lists treaty rates in Publication 901, U.S. Tax Treaties. The foreign tax credit has its own limits, set in the Internal Revenue Code and explained in Publication 514. Where a figure changes by year, the site will show it here: the Form 1116 filing threshold is the current figure, which the official source publishes each year, and the qualified dividend rate brackets are the current figure, which the official source publishes each year.

A worked example

Let me tell you about Maria, a retired schoolteacher in Ohio. She wants a small slice of a Swiss company. She finds an ADR that trades for $40 and stands for one ordinary share. The same ordinary share trades in Zurich for 36 francs. On the day she checks, one franc buys $1.11.

Here is the math on the ordinary share. 36 francs at $1.11 a franc is $39.96. So the two prices sit almost the same, as you would expect, since traders keep them close together.

Now the fees. Maria plans to buy 50 shares. As an ADR, 50 shares at $40 is $2,000. Say her broker charges $0 to buy a U.S. listed stock. The depositary charges a fee of $0.02 per share a year, so 50 shares at $0.02 is $1 a year. A small bill.

As ordinary shares in Zurich, 50 shares at $39.96 is $1,998. But her broker charges a $15 commission on foreign trades and a 0.5 percent currency markup. 0.5 percent of $1,998 is $9.99. So her extra cost to buy is $15 plus $9.99, which comes to $24.99. Her total outlay is $1,998 plus $24.99, or $2,022.99.

On this one purchase, the ADR cost her $2,000 and the ordinary shares cost her $2,022.99. The ADR was cheaper by $22.99, even counting its yearly $1 fee for the first year.

Now the dividend. Say the company pays 2 francs per share, so 50 shares pay 100 francs. For this example, say the home country holds back 35 percent at the source, a rate chosen only for illustration. 35 percent of 100 francs is 35 francs, leaving 65 francs. At $1.11 a franc, that is $72.15 reaching Maria. The withheld 35 francs is $38.85, and she may be able to claim part of that back as a credit, within the limits in Publication 514.

Her numbers are her own. Yours will differ. But the steps are the same.

Where it goes wrong

I have seen smart people get tripped by the quiet things. The first is currency. If the franc falls against the dollar, Maria's holding loses value in dollars even if the Swiss share price never moves. An ADR does not shield her from this. The ADR price already carries the exchange rate inside it. Swings both ways.

The second trap is fees that hide. A small yearly depositary charge looks like nothing. Over many years and many shares, it adds up. A broker markup on currency can quietly cost more than a visible commission. Read the schedule.

Third, liquidity. Some unsponsored ADRs trade rarely. A thin market means a wide gap between the price a buyer offers and a seller asks, and that gap is a real cost. Check the trading volume before you rely on a quick exit.

Fourth, tax paperwork. Foreign withholding is easy to overlook, and so is the credit that may offset it. Missing the credit can mean paying tax twice on the same dividend. Keep the year end tax statement from your broker.

Fifth, the company itself. A foreign firm may report on a different schedule and under different accounting rules. The SEC's investor materials note that foreign issuers can follow different disclosure standards. Know what you can read and how often.

Last, a program can end. A depositary may close an ADR program, and holders are then given a chance to turn the receipts into the underlying shares or cash them out. That is rare, but it is written into the deposit agreement.

Questions to answer before you leave this page

Do you know which currency your dividends will arrive in, and who converts it? Have you found the depositary's fee page and read the per share charge for the ADR you are looking at? Does your broker publish a currency markup, and do you know what it is? Is the ADR sponsored, and does the company file reports you can actually read? What tax does the company's home country hold back from dividends, and does a treaty in IRS Publication 901 change that rate? Could you handle it if the foreign currency fell while the stock price stayed flat? And have you checked how often the ADR trades, so you are not stuck with a wide gap between buyer and seller?