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Beware These Risks When Investing in American Depositary Receipts

American Depositary Receipts (ADRs) have been around since 1927, but they’ve lately become even hotter investment instruments because they allow foreign investors access to the lucrative Chinese stock market. Unfortunately, many investors don’t really know the risks they’re taking on when they invest in ADRs. Some are more of a gamble than others.

ADRs are especially attractive now because some of China’s market giants are issuing them. Many investors want in on the growth of companies such as:

  • Alibaba Holding Group(NYSE: BABA), market cap: US$423 billion;
  • China Mobile(NYSE: CHL), market cap: US$231 billion;
  • PetroChina(NYSE: PTR), market cap: US$213 billion; and
  • China Life Insurance(NYSE: LFC), market cap: US$116 billion.

But investors who leap headfirst into investments like these might be ignoring three significant dangers that come with ADRs.

Currency Risks

ADRs are bought and sold in dollars, but the local shares usually trade in their original foreign currency, and they’re affected by the fluctuations of that currency against the U.S. dollar. When the U.S. dollar weakens against the foreign currency-denominated shares, investors get the benefits of the stronger foreign currency. However, if the foreign currency declines in value against the U.S. dollar, then the original value of the investment (in USD) will decline, and the decline in the value of the foreign currency may erase any gains made by the foreign company in the foreign currency-denominated shares. This has happened in the case of British and Japanese ADRs.

Currency Fluctuation Example

For example, if an investor bought S$10,000 in shares of a company and the exchange rate was S$1 = US$1 at the time of the transaction, then the investment is worth US$10,000. However, if USD decreases in value by 20% then S$0.80 = US$1.00, so now the investment is worth US$12,000.

On the other hand, if the Singapore dollar value declines 20%, the U.S. investor’s shares decline to a value of US$800, because the exchange rate has become S$1.00 = US$0.80.

Turkish Lira: 2018 Collapse

That happened in 2018, as the dollar weakened while emerging markets and diversified international portfolios grew stronger. However, when the opposite happens, investors may find that they are losing money in dollar terms, even if the investment behind the ADR is performing well. For example, if you invested in ADRs that were based on Turkish companies, you would have lost a lot of money when the Turkish lira collapsed– a peril that could have only been mitigated by hedging the Turkish lira-denominated investments.

Transparency

Most investors will trade in two kinds of ADRs, Level I and Levels II and III. Level I ADRs are traded over the counter (OTC); Heineken(AMS: HEIA) and Volkswagen(ETR: VOW3) are examples of Level I ADRs. Level II and III ADRs are traded on American stock exchanges like the New York Stock Exchange and the NASDAQ. The Level II and III ADRs are registered with the Securities and Exchange Commission (SEC) and are required to comply with the generally accepted accounting principles (GAAP).

Most foreign investors are accustomed to reading and analyzing companies that report their financial data in compliance with GAAP standards. In addition, they also feel more confident about the reported financial information, because it has been audited and verified by a major accounting firm that had to comply with the prevailing accepted accounting standards, conduct, and ethics in the USA.

Level I ADRs are required to report their financial data to the Financial Industry Regulatory Authority (FINRA). Still, it is not clear how the companies compile, assess, and report that information. Since there are innumerable accounting standards used by companies all over the world, the data in such reports is of questionable value without more information on how it was gathered.

Liquidity

Liquidity refers to how easy it is to convert your investment into cash. The liquidity of an ADR depends on how much it’s traded, where it’s traded, and it’s level of volatility.ADR Levels II and III are the most liquid because they are traded on U.S. stock markets. Level I ADRs may be considered liquid if they have a record of high trading volumes.

Investors should note that ADRs can easily be delisted, losing a great deal of their liquidity in the process. During the 2008 financial crisis, a number of ADRs delisted from the U.S. stock exchanges. The sudden change in the ADR classification shook investor confidence and caused liquidity problems for the holders of the delisted ADRs.

High volatility can also make ADRs less liquid. Investors tend to be wary of purchasing investment instruments prone to extreme market fluctuations. Those investments do not have a history of giving a good return on investment (ROI), nor should they be expected to have a predictable ROI, given their unpredictable market activity.

To sum up . . .

No investment is 100% risk-free, and every investor must assess their own tolerance for risk.

The best way to guard against losses when dealing with ADRs is to research each ADR, and try to choose ones listed on the American stock exchanges, with high trading volumes and low volatility.

Hedging can also help you reduce currency risks. Investors can hedge against declines in the value of foreign currency-denominated investments by:

  • entering into currency forward contracts;
  • entering into synthetic currency forward contracts;
  • trading in currency futures;
  • investing in currency ETFs;
  • purchasing currency options; and
  • investing in hedged investments.

Currency hedging can mitigate the risk of investing in foreign markets and currencies, but it cannot completely eliminate it. Just remember that the hedging that reduces your chances of losing money if the local currency weakens against the U.S. dollar, will cause you to lose money if the U.S. dollar weakens against the local currency.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Alisa Hopkins doesn’t own shares in any companies mentioned.