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Fractional share trading – the good, the bad and the unknown

Fractional share trading - the good, the bad and the unknown

By Alan Grujic, noted investment expert and professional trader, and founder/CEO of All of Us Financial.

Fractional share trading has gained momentum in recent months with brokerages stepping over one another to offer this benefit to customers as a way to distinguish services, especially amidst the no-fees trading wars. While it may be a popular service to offer, fractional share trading isn’t the right solution for everyone. As with anything trending in the world of investing, it’s worth examining with a critical eye, considering both the pros and the cons to determine what is right for you as an investor.

As the name itself implies, fractional shares are portions of a whole share of a company. For example, as of the writing of this article Amazon’s share price was just over $2000.00. For many individual investors, especially those who want to diversify, that can be a daunting amount for just one share. Yet Amazon is a popular company that many would like to have in their portfolio. Fractional shares offer the opportunity to buy into just a portion of one share, a particularly beneficial notion as stock splits are done far less frequently these days.

The Good

There are some very attractive elements to fractional shares. For those that either don’t want to, or can’t afford to, invest the amount of money it would take to buy just one share of an expensive stock, they can buy a part of a share and invest in the company of interest.

Many companies nowadays, particularly the high-flying tech names, let their share prices get quite high without splitting their shares. Perhaps the best known company that has had a very high stock price for a very long time is Warren Buffet’s Berkshire Hathaway, Who’s BRK-A securities trade at over $336,000!  Most people could not afford to buy a whole share of this stock.  Fortunately there is a different class of Berkshire stock, BRK-B that trades at just over $220 but perhaps even that is still more exposure in one share than some people would want.

Fractional shares are also beneficial when someone is trying to create a finely balanced target portfolio of stocks. Fractions of shares allow you to more accurately target the exact exposures, as proportions of your overall portfolio that you hold in each individual security, which is something you cannot as easily accomplish with whole shares. For example, perhaps your model says to hold 1.7% of a certain stock as a proportion of your whole portfolio. Owning a whole number of shares doesn’t allow you to get exactly that proportion, but a fractional component would allow you to target that specific percentage.

The Bad

On the flip side however, there are some elements that may make fractional shares less appealing. Historically, brokers have kept the fractions of dividends that are below $0.01 that often result from owning fractional shares.

For example, if you own a share that pays $0.07 you receive that money. If you own half a share you would be entitled to $0.035 but often due to difficulties in attributing parts of a penny to customers the brokers would keep $0.005 and give you $0.03. These small fractions of a penny are not a lot, but across many customers they do add up and are a cost to owning fractional shares. In an extreme case where a low priced share pays you such that your fractional ownership is entitled to just under a penny of dividends (perhaps $0.009 cents) you could wind up not receiving any dividend and that portion could be a meaningful percentage of the stock’s value (on a $1 you would miss out on receiving almost 1% of the value, and this could happen 4 times per year with quarterly dividends).

While this may be an extreme and unlikely case, it serves to make the point that some return is inevitably lost in holding fractional shares and such return across many customers adds up to meaningful amounts of extra revenue for brokers.

The act of dividing up shares into fractions has a number of subtle aspects, and is not done for zero costs.  There are financial engineering activities in the background that, while mainstream and efficient, are not free. No surprisingly, these costs are covered through additional fees brokers charge their customers to maintain their profits. The net result is that the additional costs of offering fractional shares, rather than just whole shares, are passed on to clients.

The Unknown

Perhaps most concerning is that there are also some unknowns. It’s not clear whether market-makers will offer you the same bid and offer price quality on fractional shares that they might offer on whole shares.

You normally trade fractional shares with market-makers rather than on exchanges, and while these market-makers are obligated to match the best bids and offers available on exchanges, they are not obligated to do better than that. Sometimes they do offer better bids and offers, but it may very well be the case that they are less inclined to do that for small trades in fractional shares. They will want to be rewarded for their efforts and smaller fractional shares may require an effort that doesn’t warrant the same aggressiveness on pricing since the order sizes are so small.

Often a customer is charged regulatory fees, particularly on the selling of shares, and these fees are frequently rounded up to the nearest penny.  This could result in proportionately more fees for fractional shares.

It’s also not clear what a fractional share’s position is in the case of insolvency of the company that issues the shares, the case where a company offers stock dividends on shares, or where there is a broker-dealer bankruptcy. These may be rare events, but the underlying mechanism and financial structures that deal with these rare events are complex and the implications would require expert analysis. Many times innovative financial instruments have had unexpected downsides so it’s important to think these subtleties through for relatively new financially engineered securities.

As the industry moves to sharing more revenue with their customers, and more transparency, it’s not clear whether various revenue streams earned will be, or even can be, passed on to clients for fractional shares. For example, if the broker lends out your securities but has to lend out your fraction of a share along with all the other fractions — to create a whole share to lend out — can they or will they share some of that revenue with you? Can they or will they share some of the payment for order flow on a fractional share with you? If you have a margin account, are your fractional shares entitled to allow you to borrow against them on margin? If not, that could change your overall portfolio borrowing and cash interest costs in ways you should be aware of.

While overall fractional shares are potentially a useful customer offering, there is still not enough understanding about costs and possible unexpected effects. Fractional shares are relatively new, and the proper way to offer these products would be for brokers to fully disclose the money they make on them, and for regulators to commission expert studies to advise customers on the more subtle effects.

A tried-and-true approach

In the end, customers are likely to be better served by simply buying well-diversified and very-low- expense-ratio ETFs such as SPY than they are by using robo-advisor services to re-create SPY-like S&P500 exposure with the inherent costs and minimal benefits that are associated with the latter approach.

In other words, just buy and hold some well diversified, large, low expense ratio ETFs and don’t let yourself be the product that the creators of robo-advisor products and financially engineered products such as fractional shares want to turn you into. There just isn’t the value to be gained, if any at all, from these products over the simple approach of just buying a good ETF.  Remember, the brokers offering these products aren’t doing it for free, so if the benefits are zero or really small, the costs will outweigh them.

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