March
26, 2021
7 min read
Opinions expressed by Entrepreneur contributors are their own.
Between 2008 and 2019, the spectacular rise in the equity markets had only marginally benefited retail investors. While 401k saving plans and European pension funds saw their performance boosted by the rise in risky assets, the “stock market craze” usually observed in phases of stock market euphoria was absent, as the bull market remained a type of reserved expert domain for institutional investors and hedge funds.
But the pandemic has changed the situation. Confined to their apartments and forced to save, many households decided to move to online trading. Indeed, individual investors have interpreted the March 2020 crash as a buying opportunity. While the damage to their portfolios was significant, previous years had demonstrated the resilience of the equity market, which was quick to rebound from a shock. If the economic crisis was going to be of epic proportion, government support in the form of cheques, the possibility for many employees or self-employed people to work from home, and the massive interventions of central banks around the world comforted the vast majority of savers that better days were ahead of us. Online trading became the favorite playground for many day traders stuck at home.
In addition to the pandemic, other elements facilitated this sudden craze. First of all, the ease of use and the attractive pricing of online brokers like Robinhood or Charles Schwab, and secondly, the rise of fractional shares, a phenomenon that is taking a major role in the democratization of investing.
Related: How to Start Investing
What are fractional shares?
To allow for small investments in US stocks, some online brokers (and now banks – including FlowBank in Switzerland) allow for the purchase of a portion of a stock—a mechanism known in the US as “fractional shares.”
Let us assume that an Amazon share is trading at about 3’000 dollars. Instead of buying the entire stock, an investor can now invest only $30 in the stock and own 1/100 of an Amazon share. In the case of dividend-paying shares, the dividends will be allocated in proportion to the shares held. So, if Amazon offers a $10 dividend and you own 1/100th of a share, you will receive a 10-cent dividend.
As we will see in the next section, fractional shares were initially created at the company’s initiative. But thanks to the mechanism put in place by financial companies, investing in the stock market’s hottest stocks is now within reach of any budget.
How to create fractional shares?
Fractional shares can be generated in several ways, such as
– Dividend reinvestment plans: when a company distributes its dividends in shares rather than cash, the number of shares distributed is not always a whole number which often results in holding fractional shares;
– Stock splits: when the price of a stock reaches a high level, companies sometimes decide to reduce the unit price while allocating an additional number of shares to compensate for the loss in value. This involves companies splitting their individual shares into smaller units by applying a certain split ratio. But this does not always result in an even number of shares. If we take the example of a 3-for-2 split, three shares would be created for every 2 shares held by an investor. The investor who owns an odd number of shares will therefore end up with a fraction of a share in his portfolio. The objective for companies is to attract small holders, improve liquidity and remove a psychological barrier (many investors confuse high price with high valuation);
– Mergers and acquisitions: when two companies merge, the new common stock created to replace the two previously separate shares combines them at a predetermined ratio. This can also lead to the creation of fractional shares;
– Intentional fractional shares by online brokers (and now FlowBank): the objective is, in fact, the same as stock splitting, i.e., to improve liquidity and facilitate transactions for individual clients with limited financial means. The main difference with splits is that this mechanism is set up by financial intermediaries.
Related: 13 Easy Investing Apps and Websites for Millennials
The advantages of fractional shares
For an individual investor who wants to build a stock portfolio but has only a limited amount of cash at hands to start with (e.g., 1,000 Swiss francs), buying stocks such as Google ($2,000), Amazon ($3,000), Tesla ($700) or Berkshire Hathaway – Class A ($370,000) can be a problem. The amount available is not sufficient to purchase certain securities individually. And in any case, portfolio diversification seems impossible.
Thanks to fractional shares, it is now possible to build a diversified portfolio with a small budget or invest in Amazon with less than 1’000 Swiss francs. It is also possible to benefit from the same mechanism on some ETFs (Exchange Traded Funds) and, soon, on bonds. The strong development potential of this mechanism is also of interest to sophisticated investors.
Finally, fractional shares considerably simplify the client experience—no need to calculate the number of shares to buy according to the amount to invest. The App’s user can enter the amount he/she wants to invest—for example, $100 – and the application takes care of investing in the fractional shares. With a few clicks, anyone can build a portfolio of shares invested in their favorite brands. In a way, this is the ultimate step in democratizing finance, a notion already well integrated by entrepreneurs who have developed applications on cryptocurrencies (example: Coinbase).
What are the disadvantages of fractional shares?
Fractional shares are not bought and sold on traditional exchanges, and the only way to trade them is through a brokerage firm (or bank), which assembles and sells them on an exchange once the fractions form a full share. This can sometimes be a lengthy process if there is not a strong demand for the stock in the market. In addition, not all shares are available in fractional form. The range of choices may not be as wide as if you were buying whole shares.
Note that fractional shares do not entitle you to voting rights.
The question of costs should also not be overlooked. Some of the costs cannot be reduced, which implies relatively high costs as a percentage of the amount invested when the transaction sizes are too small. Finally, fractional shares cannot always be transferred to other brokers and banks. Owners of fractional shares usually must sell their assets back for cash. While this is not a technical problem, it can result in additional fees and taxes.
Related: The Beginner’s Guide to Micro-Investing For New Investors
Where to buy fractional shares?
As mentioned above, fractional shares have been around for decades, notably through dividend reinvestment plans, and not only in the United States. The most experienced of our readers will remember the famous Japanese “odd lots.”
Regarding the introduction of fractional shares by financial companies, M1 Finance was one of the first to introduce this mechanism in 2017. Sofi, CashApp (Square) and Robinhood followed in 2019 before Fidelity, Interactive Brokers and Charles Schwab followed suit. This offering is also attracting fractional-only platforms such as Stash.
Indeed, the statistics of the first entrants on this product offering are more than convincing. M1 Finance estimates that fractional shares represent about 40% of the trades on their platform (and more than 50% for the first trades made on the platform by new clients). SoFi calculated that the number of trades on Amazon stock is 16x greater on fractional shares than on the “full” stock. Unsurprisingly, large-cap tech stocks and Tesla are the most popular in fractional trading.
In Switzerland, FlowBank recently introduced a US fractional stock offering on its new online trading App. Initially, it offers ten of the most traded stocks on the Nasdaq and the New York Stock Exchange (NYSE). But the universe will soon expand.
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Being able to own fractional shares is excellent news for novice investors and investors with a limited budget. This mechanism allows for investment in “hot” high-priced stocks; it allows for a higher degree of diversification and greatly simplifies the experience of online trading application users. This offer is in line with FlowBank’s strategy to make trading accessible to as many investors as possible, to democratize investment.