What are Fractional Shares? Pros and Cons

Before the advent of fractional shares, it was very difficult for people to invest in well-established companies whose stock prices were quite high. As of August 16, 2022, the price of one share of Berkshire Hathaway Inc Class A (NYSE: BRK.A) was $455,170.00. It means that unless you have enough money laying around, buying shares from such a company might pose a challenge.

Let us assume one full share was one pizza pack but even though you want to eat pizza, you do not have the money to buy a full pack so you opt to buy a slice or two slices based on what you can afford at the moment. Buying fractional shares also works in a similar way; the investor decides on the particular company whose shares they want to purchase and gets a broker who deals in fractional shares to invest with.

Using the earlier mentioned price of Berkshire Hathaway Inc. shares which is four hundred and fifty-five thousand, one hundred and seventy dollars ($455,170.00). Let us assume you want a share in the company but the money you have to invest at the moment is say ninety-one thousand and thirty-four dollars ($91,034), instead of waiting until you have the full amount to purchase one share, you can opt to purchase a fraction of the share instead.

Considering the money you have at hand, you could afford to buy a twenty percent (20%) fraction of the share since that is what your money translates to.

It is common knowledge that shares represent ownership in a particular company; this means that if a company has ten thousand outstanding shares for example and you buy two hundred shares, your ownership stake in that company is 200/10,000 or simply, 2%. However, in the case of fractional shares, the investors own a fraction of the fraction of ownership. Let us illustrate with an example below:

Continuing with our earlier stated assumption where an investor buys two fractions from Berkshire Hathaway Inc. stock, the investor will now have a 0.2% of one share of that company. Fractional shares, therefore, are investment vehicles that allow investors to have partial ownership in a company as a result of the portion of shares they have been able to purchase.

How fractional shares come about

1. Stock splits.
2. Mergers and acquisitions (M&A)
3. Dividend reinvestment programs (DRIPs)

When companies decide to use equity financing for their business, they usually do so through the initial public offering (IPO) which takes them from a private company to a publicly traded company. The shares these companies offer are whole shares, one might then wonder how fractional shares come about. Fractional shares can come about in a number of different ways but the three major ways are those listed above.

In addition to these three major ways of creating fractional shares, some stock brokerage firms might split stocks that are highly priced when they have clients who want to invest in those companies but do not have the corresponding funds to purchase whole shares of the company. Reinvesting the capital gains from stocks for the purchase of shares could also lead to the creation of fractional shares.

We shall discuss the three major ways that fractional shares come about below:

Stock splits

Types of stock split

1. Forward stock split
2. Reverse stock split

Forward

The forward stock split is also known as a stock divide. It is when a company increases its number of shares outstanding by a predetermined ratio. The forward split ratio could be 3:2; where the investor gets three shares for every two shares they own, or 5:4; where the investor gets five shares for every four shares they own, or any other number that the company decides on. The increase might result in the creation of fractional shares, especially for investors who own an uneven number of shares. For instance, if the split ratio used is 3:2 and you own thirteen (13) shares, you will now have nineteen and a half (19¹/₂) shares.

Reverse

The reverse stock split is also known as a stock merge. Companies usually use this option when they do not want to buy back their already issued shares but want to reduce the total number of their outstanding shares. They can also use to option to boost their stock price especially when it has experienced a dip in price or has remained at a low price for a considerable period.

As with the forward stock split, this also uses a predetermined merge ratio such as 1:3; where every three shares become one, or 1:4; where every four shares the investor owns becomes one or any other number that the company decides on.

The consolidation of shares in this manner can also result in whole shares becoming fractional shares. For example, an investor who owns twenty-two (22) shares in a company will end up with five and a half shares (5¹/₂) shares if the company uses the 1:4 ratio for its reverse stock split.

Mergers and acquisitions (M&A)

Fractional shares could also come about when two or more companies merge to become one or when one company acquires another one. Generally, when a merger or acquisition happens, the companies involved have to combine their shares such that they have a unified number of shareholders.

As is the case with the stock split, ratios are used for this stock unification. For instance, if a company that issues penny stocks is acquired by a bigger company with large-cap stocks, it becomes necessary that their shares become combined.

This however might pose a challenge since their stock price varies greatly, to bridge this gap, they make use of a predetermined ratio. The ratio that can be used for these combinations could be the merger ratio or swap ratio or exchange ratio.

Dividend reinvestment programs (DRIPs)

The dividend reinvestment programs are mechanisms by which investors use the dividends they get paid to purchase new shares of the same company, mutual fund, or exchange-traded fund (ETF). Fractional shares can occur in DRIPs when the dividend amount is less than the share price.

For example, if you receive dividends of one dollar ($1) per share and you own thirty-seven (37) shares, the total dividend you will get is thirty-seven dollars ($37). Suppose you decide to reinvest the dividend, but the share price for one share is seventy-four dollars ($74), it means that you can only afford half a share which brings your total number of shares to thirty-seven and a half (37¹/₂) shares.

Pros and cons of fractional shares

Since fractional shares came into existence, it has made investing in shares more affordable and accessible to a wide pool of investors ranging from students who are still in college to the working class and even older people who have already retired. The reduced price of fractional shares has made it possible to own shares of household names that were previously hard to purchase due to the high price of their stocks.

These shares offer a range of benefits to those who invest in them but as is typical with any investment, it offers some drawbacks too. We shall have a brief look at the pros and cons of fractional shares in the table below.

Pros

1. Low investment amount
2. Dividends
3. Access to expensive shares
4. Diversity
5. Potential profits
6. Meeting your investment goals.

The pros of fractional shares are those attributes that serve as an advantage to investors who own them. We shall discuss these pros below:

Low investment amount

Fractional shares allow you to start investing right where you are no matter the amount of money you have. The investment principle of this type of share is that you get a fraction of a share based on the dollar amount you are ready to invest. By this, you can begin investing with an amount as low as one to five dollars ($1 – $5).

Dividends

Most fractional shares pay distributions to the shareholders just like dividend stocks. Although the dividend amount might be insignificant since you own only a fraction of the shares, it can compound over a long period of time into a significant amount. For instance, if there is a dividend payout of one dollar ($1) per share and your fractional investment in that particular share is a quarter, you will get a dividend of $0.25.

Access to expensive shares

Shares that were previously inaccessible to the larger percentage of American citizens are now readily available and a lot of people can now own fractions of these shares. The availability of these shares additionally makes it easier to invest regularly, a phenomenon known as dollar cost averaging.

Dollar-cost averaging ensures that your preset monthly payments to your brokerage account are put to use immediately instead of letting them accumulate into an amount that can get you one whole share; this way you get to start gaining on the investment as opposed to leaving your money to just lie dormant in your account.

Diversity

The low price of fractional shares makes it easier for investors to diversify their investments by investing in mutual funds or exchange-traded funds that deal in these shares. Unlike having to invest large sums on one particular Share, buying in fractional shares ensures that you can break up the money into bits and invest in a diversity of stocks.

Potential profits

Fractional shares have the potential to make good profits on your investment especially if you invest in a number of these shares found in different economic sectors. That way, you can make a profit from the diverse fractional shares that you own in these sectors; and consequently have a good return on your investment.

Meeting your investment goals

These shares make it easier for investors to meet their investment goals of owning shares of large companies. It also aids in building up your investment par time as you can invest any amount you have immediately instead of waiting until you have a lump sum to purchase whole shares.

Cons

1. Limited shareholders’ rights.
2. Low liquidity
3. Hard to transfer
4. Limited stocks
5. Trading fee

Although fractional shares offer a range of benefits to their owners, there are some cons associated with owning them. These may vary from one broker to another since trading costs, fees, minimum investment amount, etc also vary.

No voting rights

Even though fractional shares grant you participation in distributions, you will not be able to vote on matters in the share company’s managerial and operational issues. You will also not be able to be part of general or annual meetings of the companies in which you own fractional shares.

Low liquidity

Unlike the blue-chip stocks that can be easily bought or sold because they are already well established and traded daily on the stock exchange, fractional shares cannot be bought or sold that easily.

When buying fractional shares, you can only do so through stock broker’s mutual funds, or exchange-traded funds (ETFs) that offer these options. Also, when you want to sell, you will still have to do so through your stock broker. Since not every company’s fractional shares have high demand, you may have to wait until your broker gets a buyer or until you are able to acquire another fractional share to make it a whole share. This makes the waiting period before buying and selling longer.

Hard to transfer

Whole shares such as small-cap shares and mid-cap shares are more easily transferable than fractional shares. In a situation where you want to transfer your shares from one broker to another, it may come with added tax charges, brokerage fees, and other unforeseen expenses. You might also have to sell the fractional shares instead and transfer the cash to your new brokerage but as mentioned earlier, this is likely to take a longer time due to the share’s low liquidity.

Limited stocks

You have a limited choice of stocks to purchase when buying fractional shares. Unlike common and preferred stocks that numerous companies, fractional shares are usually issued directly by the companies but created by brokerages to meet the needs of their clients. Thus the stock types available might be limited to only those that your particular brokers offer.

Trading fees

Some brokerage firms that offer fractional shares charge investors trading fees for these shares; this can be a big disadvantage considering that you only own a fraction of the share and as such, the dividends and other associated profits with these shares are quite low.

Some brokerages that offer fractional shares

1. Betterment
2. Charles Schwab
3. E-Trade
4. Fidelity Investments
5. Interactive Brokers
6. M1 Finance
7. Merrill Edge
8. Public
9. Robinhood
10. Stash
11. TD Ameritrade
12. Vanguard
13. Webull

Fractional shares vs whole shares

A whole share is a single unit of share that represents ownership in its issuing company; fractional shares on the other hand are fragments of whole shares. Whole shares offer benefits such as their holders being able to participate in the decision-making processes of the issuing company, unlike fractional shareholders who have no say in the issuing company. We shall have a look at some of the similarities and differences between these two shares.

Similarities of fractional and whole shares

1. Both represent ownership in the issuing company.
2. Both present investment opportunities to investors.
3. Both can receive distributions in form of dividend payments.
4. Both are equity securities.

Differences between fractional shares vs whole shares

Frequently asked questions

Conclusion

Our discussion has been focused on what are fractional shares, we have also seen the pros and cons associated with owning these shares. We have also outlined some brokerage firms that offer these shares as well as some similarities and differences between fractional and whole shares.

As an investor with fractional shares or one hoping to invest in this equity, you must consider the pros and cons associated with these shares. Additionally, you should do in-depth research on the particular brokerage firm you want to invest in as the trading rules, cost fees, minimum investment amount, policies, etc. as these can differ between brokers.