Canadian Depositary Receipts were introduced to the Canadian investment market in 2021 and represent shares of global companies. What makes CDRs unique is that they are traded in Canadian dollars (CAD).
CDRs are traded on the Cboe Canada (Cboe) exchange, previously known as the NEO Exchange, a Tier 1 stock exchange in Canada. This provides investors another option to obtain exposure to some of the world’s largest companies, without being impacted by foreign exchange fluctuations.
They are the Canadian version of the American Depositary Receipts (ADRs), which have existed in the U.S. since 1927.
How do CDRs work?
CDRs are very similar to traditional stocks; they trade on an exchange, pay dividends and have voting rights. What makes CDRs different is that they are not stocks per se — each CDR is economically equivalent to owning a number of shares, or a fraction of a share, of a global company’s stock.
The specific number of shares is automatically adjusted daily to account for the exchange rate. If the CAD increases in value compared to the stock’s native currency, the CDR is adjusted to represent a larger number of underlying shares. Conversely, if the CAD decreases in value compared to the stock’s native currency, the CDR is adjusted to represent a smaller number of underlying shares.
This built-in foreign exchange hedge effectively eliminates the impact of foreign exchange fluctuations between the CAD and the currency of the underlying stock (i.e. USD). This means that a CDR return depends only on the performance of the underlying stock.
Lower investment price
CDRs are initially issued at a price of $20. After the initial issue, the price will change. Shares of many large companies trade at prices significantly higher than their CDR equivalent.
For example, on Dec. 13, 2023, Costco (COST-US) was trading at $637 USD per share on the NASDAQ. On the Cboe, the Costco CDR (COST) was trading at $30.18 CAD that same day.
This means CDRs make investing in these companies more accessible to Canadian investors, by effectively permitting them to purchase a small percentage of a share rather than an entire share.
Dividends and voting rights
Dividends paid on the underlying shares are passed through to CDR investors in Canadian dollars when received based on the current foreign exchange rates. Also, CDR investors maintain voting rights in proportion to the underlying securities shares represented by their CDRs.
Liquidity
The liquidity of an individual stock is based on its daily trading volume, but that is not quite the case with CDRs. Similar to exchange traded funds (ETFs), their liquidity is a function of the liquidity of the underlying security.
Generally speaking, the higher the trading volume of the underlying security, the higher the degree of liquidity of the corresponding CDR. You can observe this in the bid-ask spreads of CDRs. Even though they are not traded as much as their underlying securities, they still have tight bid-ask spreads.
Fees
CDRs don’t have any ongoing management fees, although there are more subtle embedded fees.
The way that the CDR issuer profits is by including a spread in the exchange rate used to calculate how many shares of the underlying security each CDR represents. They mention this on their website: “The FX forward rate used for the notional currency hedge will on average have a spread of less than 0.50 per cent per year.”
This foreign exchange forward rate is posted daily on their website, so you can see the different between the spot exchange rate and the rate used for the CDR conversion. On Dec. 13, 2023, the “foreign exchange forward rate” was 1.3602, whereas the spot rate was 1.3545. This constitutes a spread of 0.42 per cent.
Taxes
The Canadian tax consequences of owning CDRs are the same as if the investor held the underlying securities directly. Taxes may be withheld by the underlying company’s local government. For example, for an underlying security from the U.S., an investor may be subject to a 15 per cent U.S. withholding tax if held in a non-registered account.
Illustration comparing direct holding versus CDR
Let’s say that two Canadian investors, Karen and Robert, each have $10,000 CAD and decide to invest the same amount of money in Apple Inc.
Karen wants to convert her money into USD and buy the shares directly in the native currency (USD). Robert does not wish to convert the money into USD and wishes to buy Apple as a CDR in Canadian dollars.
For purposes of this illustration, we will assume the USD / CAD spot (mid) rate is 1.34. To purchase (the bid) USD the rate would be 1.36, and to sell (the ask) USD the rate would be 1.32.
The closing price for Apple Inc. (on Nasdaq) on Dec. 13, 2023, was $197.96 USD. The closing CDR price for Apple Inc. on Dec. 13, 2023, was $29.39 CAD.
As Karen wishes to purchase Apple Inc. directly, she must first convert the CAD to USD at the bid rate (1.36). Karen would receive $7,352.94 USD. Karen would be able to purchase 37 shares at $197.96 = $7,324.52 and have $28.42 USD remaining.
Robert is able to purchase 340 CDR shares calculated as $10,000 divided by $29.39, and have $7.40 CAD remaining. If Apple shares were to appreciate 10 per cent in value, that’s exactly the return that Robert would observe having purchased the CDR.
Assuming the same 10 per cent increase in Apple’s share price, calculating the return for Karen depends on the fluctuation in the exchange rates between USD and CAD. If the USD / CAD exchange rate was the same (1.36), the return would also be 10 per cent. If the USD appreciated five percent in comparison to CAD, Karen’s return would be 15.5 per cent (110 per cent X 105 per cent). If the USD depreciated five per cent in comparison to the CAD, her return would be 4.5 per cent (110 per cent x 95 per cent).
As you can see, buying the security directly in its native currency adds complexity to the investment decision, as the investor has to think not only about the long-term prospects of the company at hand, but also about the direction in which the exchange rate is expected to move.
Speculating on currencies
One of the higher risk forms of investing is currency trading. Done effectively, we feel that adding currencies into a diversified portfolio reduces risk and enhances returns.
The older financial textbooks often refer to owning gold during times of uncertainty. If markets get uncertain, gold is often as volatile or more volatile than other forms of investments.
From our experience, USD within an investment portfolio often provides a better hedge during uncertain times. The USD is often seen as a safe haven currency and often strengthens when times get uncertain.
Canadians investors with USD exposure will often have currency gains which offset equity market declines during these time periods. The opposite can happen as well when equity markets improve. When investors are wanting to incur more risk, the USD can often soften during those times.
Diversification
We feel strongly that investors should diversify a good portion of their investments outside of Canada. Currently over half of our equity model portfolios are invested in U.S. stocks.
The U.S. represents over 60 per cent of the world’s market capitalization and Canada represents under five per cent. Some of the best companies in the world are located outside of Canada.
Our approach to investing is to avoid mutual funds, including international and global mutual funds, that often have high embedded fees. We also avoid international ETFS as they are too diversified and still have embedded fees, although significantly lower than mutual funds.
Our primary preference is to hold the security directly to provide another component of diversification and to smooth out volatility over time.
Exchange rates
In early November 2023 we mentioned to clients that the USD / CAD exchange rate was at 1.39. We would show a chart of the USD / CAD exchange rate over the last 20 years, and it was essentially near the higher end of the range for this entire period.
When Canadians are buying U.S. companies directly, they have to look at both the share price and the exchange rate. As noted above for Karen, if the USD was purchased at 1.39 and then slides to 1.30, with the U.S. stock price remaining unchanged, the loss is 6.5 per cent. The opposite can apply as well.
No one can predict foreign exchange rates but looking at historical charts and understanding currency risk, timing of conversions can make a difference when calculating returns.
With new clients that have all funds in CAD, exploring CDRs when the USD / CAD exchange rate is at historic highs is worth considering. It is always possible in the future to sell the CDR and purchase the securities in the native currency.
In our article last week, Inter-listed stock trades can be strategic, we noted a strategy of utilizing inter-listed stocks to change between USD and CAD. When funds are moved back into CAD for existing clients, they can still maintain exposure to U.S. equities through CDRs.
Typically, this strategy would only make sense in registered accounts where tax consequences for dispositions are not applicable.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email kevin.greenard@scotiawealth.com, or visit greenardgroup.com.
