What Fractional Share Trading Coming to Schwab Might Mean

Last week I mentioned that the next innovation I was waiting for from traditional discount brokers, after commissions have gone to zero, is fractional share trading with limit orders. Not long after, in an interview with the Wall Street Journal, Charles R. Schwab said his eponymous brokerage will soon offer fractional share trading.

It's not yet clear if this will involve limit orders or if it'll be like what Sharebuilder offered so many years ago and what M1 Finance similarly offers today: you can buy fractional shares of a stock or ETF, but you can't set the price per share (limit order) that you are willing to pay. Rather, Sharebuilder and, to a lesser extent M1, let you specify the dollar amount, like when buying a mutual fund. How many fractional shares you would get, and at what price, was up in the air.

Just in case it's not clear, fractional share trading is being able to buy less than a whole share of a stock or ETF. For example, let's say stock XYZ trades around $1,000 per share but you only have $250 to invest.

With a traditional broker, you wouldn't be able to invest in XYZ unless its price per share dropped and/or you scraped together enough money to buy one share.

In the Sharebuilder of old, on the other hand, you would put in an order for XYZ and specify that you wanted to use your $250. On the following Tuesday, at some point in the day, Sharebuilder would get you $246 worth of XYZ, with $4 going to Sharebuilder as the commission fee. If XYZ traded at $1,005.25 at the time of purchase, you would get 0.2447 shares of XYZ. As another example, if XYZ traded at $995.73 at the time of purchase, you would get 0.247 shares instead.

You couldn't control how much you paid per share or how many shares you would get, but it was better than not being able to invest at all. Sharebuilder, which was owned by ING, was sold to Capital One, which then sold it to E*Trade, and this kind of fractional share purchasing became extinct.

Then, M1 Finance came along with a very similar service, the differences being no commissions and your purchase is made the same day your funds are deposited (provided the stock market is open). The major difference is the way the M1 portfolio is structured (as pies and slices), but the end result is pretty much the same in terms of not being able to specify an exact price or time that you want to buy a fractional share of a stock or ETF. With Sharebuilder you could specify at what price you wanted to sell your shares. M1 doesn’t have that option (because it's a different kind of service. It's not for traders. M1 makes automatic long term accumulation easy, as well as rebalancing your holdings.)

If Schwab (and subsequently all the other brokers that may follow) offers something similar, it will certainly be a blow to M1 because competitors will offer a similar service, but it won't be that special. If, however, Schwab lets investors buy fractional shares while specifying a price for each fractional share, that will be a game changer:

In the example above, where you have $250 and XYZ trades around $1,000 per share, you would be able to specify at what price of XYZ you want to invest your $250. So, you can set a limit order for $990 per share for 0.2525 shares. If XYZ trades down to $990, you'll get the 0.2525 shares. If XYZ stays above $990, your trade won't execute.

What I like about this is that you can use your entire investable amount (you should be able to do this with M1, but my dividend portfolio always has an unused cash balance). You're not leaving any funds in the low interest cash sweep vehicle that the broker offers. And it's not just for investors that don't have enough funds to afford one share or a stock or ETF.

Suppose you have $10,000 to invest and you want to put it in VOO, the Vanguard ETF that tracks the Standard and Poor's 500 index. Let's say you want to buy VOO at $273.69 (that was the ETF's closing price on 10/18/19). In the current, still traditional, environment, you would set a limit order for 36 shares at $273.69 per share. When the order is executed, you would have 36 shares of VOO, worth $9,852.84 and a $147.16 cash balance. If you want to invest that $147.16, you would have to find some other stock or ETF, but you wouldn't be able to put it into VOO.

But, if Schwab offers fractional share trading with limit orders, you would be able to buy 36.5377 shares of VOO at $273.69 per share. Your entire $10,000 would be invested without any crumbs being left over.

To reiterate, that's two advantages: 1) being able to invest your entire cash amount and 2) being able to specify the price per share that you want to invest at.

What this allows you to do is to own indexes without having to pay any fees whatsoever (apart from the time it takes you to set up the orders). That is, you can buy all the components of the Standard and Poor's 500 (or the DOW, Nasdaq, etc) without having to go through a fund. You can also make your own index of stocks if you want, and have all your cash invested.

The possibilities of what you can do are endless. For example, a traditional stock index might have businesses in it that you don't want to invest in because the companies' policies, products, etc (weapons, oil, animal testing, animal products, alcohol, tobacco, doing business with certain countries, and so on) go against your beliefs. With fractional share purchases, you can buy all the components of a broad market index but leave out the offending businesses. That way you can stay diversified while being spiritually happy.

You can already do this with M1, but you are limited to 100 holdings per portfolio. I presume that Schwab won't limit the number of individual holdings you can have. There are also funds that already do this, but they charge a fee and you may still disagree with some of their holdings.

If you do it on your own, you have full control. And, if limit orders are available, you can specify the exact price you want to pay for each business.

Obviously this can make things very complicated (or not--how long before brokers offer a "build your own ETF" service?--for example, Fidelity already has basket trading), but investors who want to have a simple one or two fund portfolio still have that option.

Again, it's not clear whether this is what Schwab will offer, but I am excited that it will be because of all the possibilities. We will see over the coming weeks and months. And we'll see what Schwab's competitors offer to keep up.