In November 2019, the online broker Interactive Brokers made a splash in the finance news by offering fractional shares trading for retail clients. They were the first of the major online brokers to commence this service, but Fidelity soon followed in suite, announcing in January 2020 that they would offer fractional shares trading for both equity and ETFs.
So, what is factional share trading? If we look at equity, you might have noticed that some shares are quite high-priced. One extreme example is Berkshire Hathaway Inc Class A (NYSE: BRK.A). At the time of writing, purchasing a single BRK.A share would cost you over 429,000 USD. Even with less extreme examples, such as shares costing a couple of hundred dollars, it becomes difficult for the small-scale retail trader to invest without using up a large chunk of the total bankroll – and achieving some type of sane risk management diversification becomes very difficult. But what if there was another way? What if you could gain exposure to the price movements of a share without purchasing the whole share? This is where factional share trading comes into play.
Buying and selling fractional shares
Fractional shares are not bought and sold at the stock exchanges, but some online brokers are offering them.
Some of the most well-known exchange traded companies in the world have fairly high-priced shares, and by offering fractional shares the broker makes them more attainable for small-scale retail traders. This is for instance the case for Chipotle Mexican Grill Inc. (NYSE:CMG) which is currently trading for over 1,723 USD per share.
If you had $5,000 to invest, buying even just one share in NYSE: CMG would make you put “too many of your eggs in the same basket”. In cases such as these, purchasing fractional shares can be an appealing choice that allows for better diversification.
It should be noted that part of the market demand for fractional shares come from shareholders looking for a fractional share to complete a fractional share they already own. After a split, merger etcetera a shareholder might have ended up with a lot of whole shares and one fractional share, and is now looking to turn it into a whole share. Fractional shares are thus not only sought after and bought by small-scale traders who can´t afford to buy whole shares.
How do fractional shares form?
Less than one full share of equity is called a fractional share. Fractional shares can for instance be the result of corporate actions such as stock splits, mergers and acquisitions, or how dividend reinvesting plans (DRIPs) work.
Since fractional shares can be hard to sell, shareholders are sometimes given the option of receiving cash instead of a fractional share, but for tax reasons the shareholder might prefer to get a fractional share instead of the cash.
Recently, certain brokerage firms have begun splitting whole shares deliberately to be able to sell fractional shares to their clients.
A share company can decide to do a stock split to boost the stock´s liquidity. The number of shares is increased by a specific multiple, but the combined monetary value of all shares remains the same. The most commonly used split ratios are 2-for-1 and 3-for-1. If you own one share and the company carries out a 3-for-1 split, you will end up with three shares.
Not all stock splits result in an even number of shares. A 3-for-2 stock split will give you 3 shares for each 2 shares you own. If you only own 1 share, it becomes 1.5 shares. If you own 5 shares, it becomes 7.5 shares, and so on.
When companies combine new common stock using a predetermined ratio for mergers or acquisitions, it can result in the creation of fractional shares.
A dividend reinvestment plan (DRIP) is a plan where dividend payouts to a shareholder are automatically used to purchase more shares in the company. Since dividend payments often do no match the exact cost of a certain number of whole shares, DRIPs frequently create fractional shares.
Automatic reinvesting of capital gain distributions and dollar-cost averaging programs can also result in the creation of fractional shares.