Fractional shares, as the name suggests is investing in a fraction or a small portion in a company’s share. The main difference here is that instead of purchasing one stock at the full share price, you buy a small part of the share.
Fractional share investing is relatively new and comes on the back of advancements in investing. Traditionally, if you wanted to invest in stocks, you are required to purchase a minimum of one share (if not more).
While this is easy for large investors, for the average retail investor, some stocks are out of reach.
For example, the stock price of Warren Buffet’s Berkshire Hathaway (NYSE: BRK) is $424,201.00
Given that this is the price of one share in BRK, it is almost impossible for many retail individual investors.
Fractional share investing breaks this gap by allowing you to own a small portion of the share. Hence, you could one percent fractional share in BRK, which would now come to $4,242.00.
However, the reader should know that fractional shares have existed for a long time.
Fractional shares have existed for a while
Up until recent times, an investor could not directly invest in fractional shares. These were possible only if you already owned full shares of the company. Thus, traditional investors have ended up owning fractional shares.
If you have invested in the equity market, chances are that you might have ended up with a fractional share.
Some of the most common examples include
- Stock splits:A stock split is when a company splits its stock to raise money. A stock split of 1:2 would mean that investors receive 1 additional share of the company, for every two shares owned. Thus, if you owned one share, you would receive half a share according to the stock split. This is a fractional share.
- Dividend investing: In dividend investing, the investor typically purchases a certain number of shares in full. When the dividends are declared, investors then use this to purchase additional shares. These additional shares could involve purchasing fractional shares in the stock as well.
- Stock mergers and acquisitions: In the area of mergers and acquisitions, the acquiring company exchanges the stocks for new shares. They use a stock ratio, and these can involve in a concept similar to stock splits. Consequently, investors can end up fractional shares.
Besides the above typical methods, mutual funds also make it possible to own fractional shares. However, mutual funds are somewhat different to directly owning the shares. Hence, one could argue that fractional shares via mutual funds is an indirect form.
The emergence of fractional share investing
As more and more online stock brokerages compete for market share, fractional share investing is the result of this competition.
The concept of allowing retail traders to own a fraction or a part of the share is relatively new. This article from the Washington Post outlines the pros and cons of fractional share investing. It presents arguments for and against fractional share investing.
But more importantly, the article talks about how fractional share investing grew 344% during the first six months of 2020.
This is something that one simply cannot ignore.
How do fractional shares work?
At the heart of it, fractional share investing is the process of buying a small portion of the share.
This is the smallest exposure an investor can get to a company. The best way to understand this is through an example.
Let’s take the example of Apple Inc (NYSE: AAPL). A traditional investor would purchase a certain number of shares in the company. Each share is priced at $124.00.
Now if one would want to invest in fractional shares in Apple, they can buy one percent or five percent of the share.
This would mean that the cost of owning a fractional share in Apple Inc is now $1.24 (at one percent) or $6.2 (at five percent).
Hence, an investor with $100 for example can own five percent fractional shares in Apple Inc. The remaining $93.8 can be used to invest in purchasing fractional shares in other companies.
The main benefit of investing in fractional shares is this: You don’t need the same upfront capital as you would if you were to invest in a traditional form of investing.
But with fractional share ownership, comes a lot of questions as well.
How and where to buy fractional shares?
Investors can purchase fractional shares at select online stock brokerage companies. Some of the names include Charles Schwab, Fidelity and relatively new entrants such as Robinhood, Sofi Invest.
These online brokerage companies charge a fee for purchasing fractional shares. The key for investors is to look for stocks or to invest in fractional shares accounting for the trading commissions. If the fees that you pay is higher than the cost of owning the fractional share, it isn’t worth it.
In order to break even on such an investment, you would need to see a high return on the stock, which is not the case all the time.
To help with this, investors typically break down their investments into holding fractional shares of different companies. This method allows them to diversify their portfolio without having to depend on returns from just one company.
Another important concept to bear in mind is that fractional share investing is not possible on all US listed stocks. Many brokerages limit fractional shares only to the big names. Thus, the most common stocks whose fractional shares you can buy are those in the S&P500 index.
The next question one may have is about dividends. What happens when you own a fractional share, and that company pays dividends?
Do you get dividends with fractional shares?
With fractional share investing, you are actually owning a fraction of the share. Thus, you are entitled to the ownership of the fraction of the share. This means that you are also entitled to the dividends that the company pays out.
However, dividend payments per share is usually small. For example, if a company announces a dividend of $1 per share, and if you own one percent fractional share, you will end up with a dividend of just $0.10 (ten cents).
This dividend does not amount to much and as you can see, you will need to scale up your purchases. This example also goes to show how investors cannot expect to make big returns on their investment with fractional share investing.
Can you sell fractional shares?
Yes! Since you fully own a fraction of the share, you can sell it. However, it is most likely that you will be selling your fractional share to the broker. Hence, there will be a mark-up on the prices, which can further erode your investments.
Why would anyone want to buy fractions of shares?
The reasons for investing in fractional shares can depend on a number of factors. An investor may not have a large amount of capital. Or an investor may want to diversify their holdings but investing only in small amounts.
The general argument with fractional share investing is diversification. But the fact that investors can diversify even when using a traditional form of investing.
For example, you can buy 10 shares each in any three US-listed companies of your choice. This is nothing but diversifying across different sectors in the same asset class.
With fractional shares, you are basically doing the same thing, but at a much smaller scale. The main downside to this form of investing is that you cannot expect to make the same set of returns as you would with a traditional form of investing.
A one percent return on an investment of $100,000 is certainly higher than a one percent return on $1000.
What are the risks of fractional shares investing?
The main difference between owning a full share versus a fractional share is the percentage of the share that you hold. Everything else remains the same. Hence, the risks involved with investing in equities are just the same as with fractional investing.
Your portfolio will be exposed to the same price swings and volatility as a traditional portfolio would. In terms of tax, the same long term capital gains is applied to fractional investing. The only difference is that the amount you pay for gains on fractional investing is much lower.
What is unique about fractional investing?
For what it's worth, fractional investing does have a distinct advantage.
Take for example an investor with $100. There is a stock that they are interested in, which trades at $100. In a traditional form of investing, this investor may use all their trading capital to purchase one full stock.
In this scenario, they are completely exposing their risks to this single company.
Through fractional investing, the investors can purchase one percent fractional share spread across 10 different companies. In this approach, their investment is now diversified.
Thus, as long as the stock picks are diversified, the declines in one company’s stock can offset the gains in another company’s stock in their portfolio.
In some ways, this is similar to an investor diversifying their portfolio by investing $100,000 of the trading capital across different companies.
Pros and cons of fractional share investing
So far, we have an understanding of fractional share investing and how it works. Let’s summarize the above by citing the pros and cons of fractional share investing.
What are the advantages of investing in fractional shares?
Fractional share investing allows you to start investing in small amounts. This is especially useful for those who are new to investing in the equity markets.
There is no requirement to have a large trading capital and this low level of entry makes it very popular for first-time investors. Since the amount invested in lower, the risks are also lower, relative to traditional investing schemes.
With fractional investing, you have the option to diversify into different stock sectors without raising your costs of funding. Investors are entitled to the percentage of the share that they buy including dividends.
Many online brokerage apps make it easy to invest in fractional shares. Thus, one does not have to be tech-savvy to start investing in the markets.
With fractional shares, you are also able to invest in not just stocks but also a choice of ETFs or exchange-traded funds. This enables you to further break down your investments across different markets.
Last but not the least, dollar cost averaging is the biggest advantage. Through this, investors can set aside a fixed amount of money to invest. This means that there will be times when the amount you pay per share is lower than purchasing the full share itself.
What are the disadvantages of investing in fractional shares?
Fractional share investing is something that has started as a trend only recently. Hence, when it comes to the choice of stocks, you don’t have that many.
Most online stock brokerages allow fractional investing in only a select set of stocks. Most of the time, these stocks are the S&P500 listed companies, which are large-cap companies. Hence, if a mid-cap or a small-cap company caught your fancy, fractional investing in such stock may not be possible.
Another cause for concern is the liquidity in fractional share investing. The way it works is that the broker splits up the shares that they own. Hence, if there is not enough demand for the share, you might incur higher costs due to liquidity.
Since fractional share investing is only starting, the demand is yet to pick up. But one could avoid this by carefully selecting an online brokerage that is popular for fractional share trading.
You will not get any shareholding rights with fractional investing. But this should not be a cause for concern for many. Most investors take to fractional investing as a hobby or just to test the markets. Hence, for such investors, shareholder rights are the least important of all.
Investors are also unable to transfer their fractional shares between brokerage accounts. This is not the case if you own full-shares in a company. Fractional shares are enabled between the broker and their customers. Hence, transferring a one percent fractional share between brokerage accounts is not possible, at least at this point in time.
For all the pros and cons, fractional share investing is certainly a welcome decision. The benefits clearly outweigh the cons of investing in fractional investing. The biggest beneficiary from fractional share investing is the retail trader.
While it is a different story about the potential returns one may make, fractional share investing allows traders easy access to the stock markets without having to put up too much capital. Thus, fractional share investing allows just about anyone with a little money to own a fraction of the equity markets.
