If you only invest in domestic stocks, you’re only accessing about one-third of the world’s stock market. To diversify to your portfolio, consider investing globally. That means investing in companies that are headquartered in countries such as Japan, Germany, South America, or Africa. Even if you can speak Japanese, it wouldn’t be easy to pick up the phone, call a stockbroker in Japan, and place an order for 100 shares of Sony. You’d have to convert your dollars to yen, hope you get the shares, and worry about collecting your dividends.

To eliminate those problems, J.P. Morgan invented American Depositary Receipts (ADRs) in 1927. ADRs of a foreign company are created when its shares are deposited into a designated U.S. bank in the company’s home country. The bank then issues receipts, or ADRs, that trade on U.S. exchanges in American dollars. U.S. investors then can buy the ADRs through their stockbroker just like any other U.S. company’s shares. 
Depending on the price structure, one ADR may represent several shares or just a fraction of a share of the underlying foreign stock. The number of shares the ADR represents is known as the ADR ratio.

"Many countries used to impose a legal requirement that anyone who wanted to purchase stock in their companies had to be a citizen of that country," says Mike Stevenson, chief of enforcement of the Washington State Securities Division. "That prevented U.S. citizens from buying that country's securities. Those countries did, however, allow ownership through ADRs because the securities aren’t owned directly."

ADRs actually offer foreign companies many benefits. Through an ADR program, management can improve their company’s visibility in the world’s markets, increase their shareholder base, and improve their stock’s liquidity. 

When U.S. investors buy and sell ADRs, the transactions settle in three days just as all stock trades do in the United States, rather than whatever the settlement period might be in that foreign country. The dividends on ADRs are paid in U.S. dollars, rather than the local currency where the company is located. ADR dividends also are taxable just like the dividends on U.S. stocks, and investors receive a tax form 1099 at the end of the year. A portion of those dividends, however, will be withheld. Investors can recoup that money by filing for a foreign tax credit when they file their income taxes. 

While ADRs make it easier to purchase individual foreign stocks, you should consider a few additional issues when using these investment vehicles. 

“You have to understand how the currency fluctuations are going to affect your returns, and you should know a little bit about the economy of the particular country,” says Robert Dufresne, certified financial planner with Planned Financial Security in Orlando, FL. “It adds another layer of complexity to stock picking.”

Currency risk can cause an investor to lose money on a stock whose price has actually increased in the issuing country. If an investor owns the stock of a French company, and the price increases, but at the same time the dollar appreciates against the French franc, the currency fluctuation may wipe out the gain. Of course, the reverse also is true. A declining stock price may be buoyed by a depreciating dollar. Currency risk can make the return on an ADR more volatile.

Investors trading ADRs not only need to research the company they’re buying, but also the status of the country where the company is located. You certainly don’t want to buy into a company that’s in a country that’s about to have a revolution or whose economy is about to collapse. Military personnel may have an advantage in this area.

“Military people may have lived in a particular country and understand that country’s culture and even have some insight into the company,” says Stevenson. “That may make it more suitable for them because they understand the politics of it better. It may help them to have a more successful investing experience.”

Depending on which ADR an investor is researching, information may be difficult to obtain. While all ADRs that trade on U.S. exchanges are required to file financial statements, the statements of foreign companies may not be as timely as those of U.S. companies. Also, especially with smaller companies, there will be accounting inconsistencies in foreign financial statements versus U.S. financial statements. To alleviate those problems, it’s best to stick to the ADRs of larger companies that are traded on U.S. exchanges. 

An ADR may be sponsored or unsponsored. If the foreign company has chosen a single U.S. bank to act as the depositary and transfer agent for its shares, meaning the ADR is sponsored. An unsponsored ADR occurs when demand for a specific foreign stock is great, and a broker or bank purchases the shares and deposits them in a depositary, creating more than one depositary for that stock. 

For a stock to be listed on a major U.S. exchange or to be quoted under the Nasdaq system, it must be a sponsored ADR. For most investors, it’s wise to stick to ADRs that are sponsored. ADRs that don’t trade on exchanges, but instead trade over the counter on pick sheets, may have liquidity problems.

“If there isn’t a large float of the company’s securities in the United States, there won’t be enough buyers or sellers, and liquidity problems can cause the price of the stock to be depressed,” says Stevenson.

The primary reason for investing in foreign companies is to give an investor’s portfolio an added amount of diversification. Before you jump in, however, you need to review your current portfolio. You probably don’t want more than a 15 percent international exposure in your portfolio. If you own mutual funds, you already may have a small number of international stocks in those funds. Find out your percentage of foreign funds and then determine how much more of the portfolio should be international. That 15 percent can help your portfolio grow, despite downturns in the U.S. market.

“Certainly there are times when our economy may be weak or going into recession, but other parts of the world’s economies are stronger than ours,” says Dufresne. “It just adds another layer of diversification to your portfolio.”

To get that diversification, however, an investor should look at different parts of the world. Buying 10 German ADRs doesn’t add much to a portfolio. It’s better to buy the ADRs of companies in several different countries. Also, an investor would want to vary the industries the ADRs represent. Don’t buy a German, Japanese, and British pharmaceutical company. Instead, buy a German pharmaceutical company, a Japanese manufacturing company, and a British insurance company. The more ways a portfolio is diversified, the lower the risk.

If you aren’t used to purchasing individual stocks, ADRs may not be the right investment vehicle to use to add an international flavor to your portfolio. The other option would be to use international mutual funds, and let the mutual fund manager worry about liquidity, currency, and political risk. Using a mutual fund, however, means paying an additional fee for that person’s expertise. Deciding whether to use ADRs or international mutual funds is the same as deciding whether you want to build your own investment portfolio by picking individual stocks or by using a mutual fund, which will require you to pay an additional fee for the manager’s expertise. If you choose to use ADRs, it’s important to research the investment just as if you were buying the stock of an American company.

“You need to be selective and do the same basic fundamental analysis,” says Dufresne. "Don’t think you’re going to add diversification to your portfolio just by purchasing a bunch of ADRs. There has to be a good reason for the investment other than the company is in a country where you want exposure. It won’t be a good investment if the fundamentals are not there.”

Every investment portfolio should have a bit of international flavor. How each investor accomplishes that is a personal decision. If you have enough money to buy shares of several ADRs in various countries and industries, and you’re willing to do the research required for buying individual stocks, ADRs may work. If you’d rather leave the work to a professional manager, an international mutual fund is probably a better bet. 

“I would not discourage people from using ADRs,” says Dufresne. “But if you use them, you have to do your basic research, and know what you’re doing when you buy them.”

If you’re considering greater diversification, why let two-thirds of the world’s stocks pass you by?