The Fight For Fractional ETF Trading

January 01, 2020

[This article appears in our January 2020 edition of ETF Report.]

In October, discount brokerage Charles Schwab made waves when it announced it planned to introduce trading of fractional stock shares in 2020, as part of a broader effort to entice younger investors to its platform.

Fractional ETF shares, however, aren’t yet in the cards.

“We are … exploring how fractional share trading could be applied in other areas, such as with ETFs, but our focus right now is on individual stocks,” Schwab spokesperson Erin Montgomery told ETF Report.

Fractional trading is considerably more difficult to implement for ETFs than it might at first appear, and it remains one of the last clear advantages mutual funds have over their exchange-listed cousins. Because mutual funds can be bought and sold in partial shares, they’ve managed to retain dominance in 401(k)s and other retirement accounts, of which roughly half of all Americans have.

So what makes fractional ETF trading so difficult, and is there any way to simplify it for the masses?
Or is the best solution simply not to bother?

Easy For Mutual Funds
For a decade or longer, fractional trading has been something of a holy grail for the ETF industry, a deceptively simple concept that’s been exceedingly difficult to put into practice. The reason strikes to the heart of what differentiates mutual funds from ETFs.

Although mutual funds and ETFs are pooled investment vehicles, investors can only buy in or sell out of mutual funds once per day, after the close of market hours. Once the mutual fund’s net asset value (NAV) is calculated, based on the closing prices of all the securities in its portfolio, the fund manager then creates and redeems shares of the fund in cash. This means any investor wanting to buy shares gives their cash to the manager, who then creates exactly the amount of shares determined by the NAV. For example, your $150 would buy 1.5 shares of a mutual fund whose NAV is $100.

As a result, fractional shares of a mutual fund can and very often do arise, simply to make the bookkeeping work. And there’s no problem with execution, because every in and out transaction happens via the fund company itself.

ETFs, however, are exchange-traded, meaning their shares are listed on exchanges, and exchanges don’t allow investors to buy partial shares of securities. Whether you’re an authorized participant building a new ETF creation unit or a retail investor purchasing shares through their brokerage, you simply can’t buy fractional shares of an ETF, no more than you could buy fractional shares of Amazon (AMZN).

ETFs Have A Lower Investment Threshold
Usually this isn’t a problem, given that the bar for investment in ETFs tends to be lower than for mutual funds. Typically, ETF investment minimums are much lower than those for mutual funds, which can cost $1,000, $3,000 or even $10,000 per share. Even individual stocks can get pricy; for example, Berkshire Hathaway (BRK) currently costs a whopping $326,100 per share.

Still, for investors with smaller asset prices or precise target allocations, per-share prices of ETFs can get hefty, especially for the largest and most liquid legacy ETFs with high brand recognition. Several of the top 10 largest ETFs are also among the most expensive; the most expensive-per-share ETF is the SPDR S&P Midcap 400 ETF Trust (MDY), which currently costs $361/share (see Figure 1).

Therefore, fractional trading of ETFs would not only allow sophisticated investors to more precisely replicate ETF model portfolios, but it would also allow investors with smaller asset bases to start building broadly diversified portfolios.

Fractional ETF trading can also improve the efficiency of tax-loss harvesting, while avoiding the cash drag on returns introduced by the remainder of an investor’s assets that cannot be invested in whole shares.

Some Fractional ETF Trading Available
Some brokerages already allow for partial-share ownership of ETFs by inserting themselves as a sort of middleman: They bundle all the necessary trades across their various client accounts, then they buy and sell in lots of whole ETF shares, as needed. Those shares are then put in a collective trust, shares of which can then be redistributed to their clients on a fractional basis.

M1 Finance, for example, allows investors to invest in fractional amounts of ETFs as granular as 1/10,000th of a share. Other independent brokerages, like Stockpile and Social Finance, also allow fractional ETF trading, as well as some robo advisors like Betterment.

In addition, in November, J.P. Morgan quietly rolled out fractional ETF trading for some users of its You Invest robo platform, making the service available to accounts with less than $5,000 in ETFs and cash. 

Fractional ETF Trading Risks
Allowing fractional ETF trading requires a certain amount of scale, however, while also introducing some risks. Since the firm must trade in whole lots, it will assume some risk in owning the “leftover” fractions of ETFs—though if the brokerage trades in enough bulk, that risk may be small.

Furthermore, there’s a cost to managing the trust into which the whole ETF shares are placed. Usually it’s only on the order of a few basis points, but that can add some cash drag.

In addition, since fractional trading is tied to a collective trust managed by the brokerage, generally it can’t be accessed outside the context of a brokerage account. This means that if a client wants to transfer funds to another account or liquidate assets, they’ll likely lose their fractional holdings. The partial shares may then be converted to cash or even sold, at which point the investor would be on the hook for any resulting capital gains.

Finally, the unavoidable truth is that no matter how small a slice of a share is offered, it still may not be precise enough for some investors’ needs. For example, 1/10,000th of one share of MDY is about $0.04, meaning an investor who wants to trade in chunks smaller than that will have to accept some rounding error, however small it may be.

 

 

 

Use ETFs In 401(k)s?
These risks aside, partial-share ETF trading opens up investment to the lowest-asset-base investors, encouraging market participation at younger ages.

It also makes it easy to regularly invest small amounts of cash, i.e., dollar cost averaging—such as that done through biweekly paycheck contributions. Therefore, if and when brokerages like Schwab decide to offer fractional ETF trading, it could dramatically improve the attractiveness of using ETFs in employer-offered 401(k) plans, for example.

However, trading commissions could still chip away at the utility of fractional ETF trading in 401(k)s, given that in some or many cases, a $4.95 or $9.95 buy/sell cost significantly outstrips the price of the underlying fractional ETF share. Yet the industry appears to be shifting more and more to commission-free trading; in recent months, Interactive Brokers, TD Ameritrade, E*Trade and Schwab have dropped commissions on all trades.

That said, the real solution to the aforementioned problems of cash drag and imprecise investment allocations might not be fractional ETF trading at all, but the de-bundling of securities from the ETF packaging entirely, through direct indexing.

Via fractional stock ownership, direct indexing allows investors to precisely allocate their cash to the securities of an index, without the use of any pooled investment vehicle. Until recently, direct indexing was only available to the highest-asset investors. But newer services, such as Orion, bring this technique to advisors and investors with lower and lower asset bases.
If direct indexing takes off in retirement accounts, fractional ETF trading may indeed become a true holy grail: a once-prized treasure that everybody’s given up seeking. 

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