With current growth rates in many international markets outpacing growth in the U.S., many individual investors are casting a longing look at the foreign markets.
Mutual funds that invest overseas are one approach to foreign diversification. But for investors who want to purchase individual foreign stocks, American depositary receipts (ADRs) offer an alternative.
An ADR is a negotiable certificate that trades like a common stock; it is issued by a U.S. bank and represents shares of a non-U.S. publicly traded company. They are priced in U.S. dollars and owners avoid many costs associated with direct foreign investment.
To help fuel interest in their ADR offerings, several banks have set up investor-friendly direct purchase plans (DPPs). As international returns have recently beaten the U.S. markets, DPPs have grown in popularity, and the banks have increased their number of company offerings.
Three bank programs, in particular, give investors many ADR offerings with favorable purchase and reinvestment options; they are presented in Table 1, along with a description of the features of their programs.
International-based DPPs operate just like domestic-based DPPs. Purchases are in U.S. dollars, and dividends are paid and reinvested in U.S. dollars. These plans also offer the same benefits as most traditional reinvestment plans. Although the international programs are similar to the domestic programs, there are a few minor differences.
For example, purchase fees, which are charged each time you send money to buy more shares, are $5 if you pay by check or typically $2 if the funds are auto-withdrawn. While these rates are reasonable and lower than typical brokerage fees, they are higher than many of the “low-cost” or “no fee” plans offered on hundreds of U.S.-based companies.
In addition, all major international programs are charging fees on dividend reinvestment, while the majority of domestic programs are not. Dividend reinvestment fees will cut slightly into your returns. Depending on the program, 5% of your dividend payout may get deducted prior to repurchase. That deduction is capped at $2.50 per transaction in the Global Invest Direct Program and capped at $5.50 in the Global BuyDIRECT program.
Like the domestic reinvestment plans, international DPPs will regularly mail paper statements, which include new purchase and dividend reinvestment transactions. Each transaction will include key information, such as date, number of shares, price per share, and fees withdrawn.
And, as with domestic reinvestment plans, it is your responsibility to keep track of your own cost-basis information. When you sell shares, it will be your responsibility to accurately calculate your capital gains and report them to the IRS.
Since ADRs are traded in U.S. currency and dividends are paid in U.S. currency, there is little difference in how they are taxed in the U.S. Dividends, whether reinvested or not, will be typically taxable as “qualified dividends,” just as they would from a U.S. company. Under current IRS rules, this means that the dividends will usually be taxed at a lower rate than ordinary income.
However, many foreign firms also will be required to withhold a portion of the dividend as a “foreign tax.” The plan administrator will document the amount of foreign tax withheld each year. This amount can typically be recovered in the form of a tax credit, by filing an IRS Form 1116 (Foreign Tax Credit). As an easier (though less beneficial) alternative, you may deduct the foreign tax paid amount as an investment expense on your itemized deductions form.
Of course, many factors should be considered when evaluating international investment options. For example, dividend yields are typically lower on international ADRs. In addition, in emerging markets, price volatility is often greater as compared to U.S. stocks.
And although ADRs are traded in U.S. currency, they represent ownership in a foreign-based stock, so its performance will also be tied to the relative value of the U.S. dollar against the parent company’s foreign currency. As the value of the U.S. dollar drops, prices of ADRs will typically go up, and vice-versa.
Lastly, do not overlook the issue of diversification. ADRs do not represent the full universe of foreign stocks, and the foreign ADRs that have a direct purchase plan will further limit your universe. By investing exclusively in ADRs with DPPs, you may end up with a portfolio overweighted in certain market segments. Instead, you should consider ADRs and companies with DPPs within the context of your entire investment portfolio.