American Depository Receipts could be a good investment – but are there any disadvantages to holding them? Like every other investment that exists, the answer to that question is yes.
Let’s take a look at some of the potential drawbacks.
1) Foreign exchange risk – it is important to bear in mind that although your investment is valued in US dollars, and dividends are paid in that currency, the underlying investment is still exposed to foreign exchange fluctuations which can significantly increase the overall volatility of your financial return. Investors should be wary of investing in countries which have historically experienced large swings in exchange rates, hyper-inflationary economies or currency revaluations. Even so, you will still be exposed to changes in the value of the US dollar.
2) Selection choice – unfortunately, not every foreign company makes it stock available through this method, often because they do not feel it is necessary to access US markets in this way. You may, therefore, encounter a situation where there is a sector or geographical area that you wish to invest in, but your first choices do not offer this type of investment vehicle.
3) Illiquidity – even if a company does offer this type of instrument, trading may be thin (especially if the company is not well-known in the United States) and, as a result, it could be difficult to either acquire or dispose of the investment in accordance with your desired timelines. Accordingly, these investments may not be suitable unless you are looking to hold them for the long-term.
4) Diversification risk – as with other investments, it is important to diversify appropriately. If you lack sufficient capital to invest in a reasonable number of these instruments (e.g. more than 20), then you will not be adequately diversified. As noted above, because of scarcity and illiquidity of these instruments, diversification is made somewhat more difficult to accomplish.
5) Withholding and other taxes – as the underlying investment is overseas, the country where the business operates may withhold taxes on dividend payments. In the UK, American Deposit Receipts also attract a 1.5% stamp duty reserve tax. Although, in most cases, you will be able to receive a tax credit to offset these amounts, there will still be a timing delay compared to receiving dividends on a gross basis from a domestic company.
6) Additional fees – the holding vehicle for the underlying shares incurs a number of incremental expenses in managing the entire process, compared to regular stocks, and will pass these on to the investor – usually by deducting them from dividends.
7) Documentation flow – a relatively minor point, but one to be aware of, is that the flow of regulatory documents, such as proxies, may be delayed as they are routed via the holding company of the underlying shares. In most cases, this is not expected to cause significant issues.
Investing in a ETF or mutual fund would overcome some of the above drawbacks, but, of course, such investments have disadvantages of their own.