One of the routes investors take to access the stock markets of other countries and invest in listed companies is through depositary receipts. A depositary receipt or DR is a negotiable financial security or financial instrument that enables individuals or organizations to invest in the stocks or hold shares of foreign public companies. Investing in a DR is somewhat similar to investing and holding stocks but with notable drawbacks and limitations that are somewhat similar to the less direct nature of investing in the equity funds of exchange-traded funds and other types of pooled funds like mutual funds and unit investment trusts.
Explaining Depository Receipts: What are Depositary Receipts and How Do These Securities Work?
Definition and Examples
Remember that a depositary receipt is a type of negotiable security. It is considered both negotiable and a type of security because it can be bought and sold or traded on a stock exchange. It is also transferrable without significant legal restrictions. This makes it similar to a stock or bond in this regard.
Furthermore, because it is a financial security, it also has an underlying value that is represented as ownership in underlying shares of a foreign company. A depositary receipt is also fungible and standardized. This means that one depositary receipt is equivalent and interchangeable with another of the same type.
There are different examples and types. Those that are listed and traded in the United States are called American Depositary and those that are issued in Europe are called European Depositary Receipts. Others that are listed and traded in other countries or markets are generally called Global Depositary Receipts.
Working Principles
It is important to note that banks typically handle the issuance of depositary receipts and their listing on local stock exchanges. A specific depositary receipt represents shares of foreign public companies held by a bank in the home country of the investor. Several securities brokers also issue depositary receipts.
The aforementioned illustrates the fact that these securities provide a venue for foreign companies to make their shares available in different countries. This also enables global investors to invest in the stock markets of foreign countries. The overall and shared net benefit is the promotion of international investment.
Nevertheless, to understand further how depositary receipts work, take note that local banks that offer them hold actual shares of foreign companies. These banks act as custodians of these shares and list them as depositary receipts in local stock exchanges. Investors can buy and sell them in these exchanges.
Advantages and Disadvantages: What are the Pros and Cons of Investing in Depositary Receipts?
Notable Advantages
The biggest advantage of depositary receipts is that they facilitate investing in foreign stocks minus the need for the shares to leave the home countries. This translates to specific benefits for investors. Take note of the following advantages of investing in depositary receipts:
1. Access to Foreign Stock Markets
One of the specific advantages of investing in depositary receipts is that they provide an avenue for local investors to invest in foreign public companies. For example, for someone living in a country in Southeast Asia, these securities allow them to access the U.S. stock market or stock markets in Europe.
2. Promotes Investment Diversification
Furthermore, because they allow access to foreign stock markets, investing in them can also help in creating a diversified portfolio of stocks and other securities. The selection of companies can range from mid-cap and large-cap stocks to value stocks or growth stocks and cyclical stocks and defensive stocks.
3. Less Expensive Than Stock Investing
There are several reasons why investing in depositary receipts is less expensive than directly investing in stocks. These include the elimination of foreign transaction fees and brokerage fees. Most depositary receipts also have lower minimum investment requirements because they represent fractional shares.
4. Some Advantages of Stock Investing
Another benefit of investing in depositary receipts is that it can afford investors with some of the notable advantages of investing in stocks. These include a higher potential for capital appreciation compared to more conservative securities. Some also represent dividend-paying stocks. Others have voting rights.
5. Shield From Currency Fluctuations
Most can also shield investors from fluctuations in foreign currencies if denominated in local currency. Another benefit of local currency denomination is that it makes it easier for investors to use their cash to invest in foreign assets. It is still important to note that some are denominated in foreign currencies.
Main Disadvantages
The central drawback of depositary receipts is that they do not afford the same benefits as investing in stocks. There are also shared or common and unique risks involved. The following are the specific disadvantages of investing in depositary receipts:
1. Exposure to Stock Investing Risks
Stocks are riskier investments compared to bonds and money markets. Nevertheless, because depositary receipts also represent shares of pubic foreign companies, they expose investors to the risks inherent to stock investing. These include market risks, management risks, interest rate risks, and regulatory risks.
2. Limited Benefits Versus Stocks
There is a difference between investing in stocks and investing in depositary receipts. The latter can be more complex to trade or liquidate compared to direct stock ownership. Most also have limited or reduced voting rights compared to holders of common stocks or other share classes of common stocks.
3. Specific Currency Fluctuation Risks
A depositary receipt can also expose an investor to currency exchange rate fluctuations between the local currency in which it is traded and the foreign currency underlying a foreign public company and the currency. It is important to reiterate that this risk is limited to depositary receipts denominate in local currencies.
4. Notable Concerns Over Liquidity
These securities are considered liquid because they can be sold or traded back in stock exchanges. However, compared to direct stock ownership and even in holding bonds, they are still considered less liquid in some cases. This is true for receipts that represent smaller companies in less attractive markets or industries.
5. Limited Foreign Company Selection
Another critical disadvantage of depositary receipts is that they are not as exhaustive as the list of stocks in a specific stock exchange or market. Not all foreign companies offer them. Some foreign companies that offer them and have tapped local banks for their issuance limit access to institutional investors.
6. Potential Economic and Political Risks
Investors can also be confronted with economic issues and political challenges unique in countries where foreign public companies operate. These include economic recession, stock market downturns, geopolitical tension, and sociopolitical upheavals. These require an external analysis of prospected companies.
7. Investment Cost and Tax Implications
They can be more cost effective than direct ownership of foreign stocks but this does not mean that they not have associated costs. Banks that issue them impose custody fees and can also withhold taxes on dividends. Both can eat returns over time. The bid-ask spread is also wider than direct stock trading.
