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Fractional shares will let small investors buy big stocks

Fractional shares will solve problems of asset allocation.
Fractional shares will solve problems of asset allocation.

Summary

  • Embracing fractional thinking might be straightforward in arithmetic but poses regulatory challenges in company law and taxation. Nonetheless, adopting this approach could level the playing field for India's retail investors.

The ministry of corporate affairs (MCA) and the Securities and Exchange Board of India (Sebi) are considering allowing the issuance and ownership of fractional shares, Mint has reported. This is a concept that’s caught on in the US where such shares have garnered popularity among retail investors. Currently, Indian regulations prohibit ownership of less than a whole share.

However, the International Financial Services Centres Authority (IFSCA) at GIFT, handling forex-denominated assets, facilitates trading of fractional shares within its regulatory sandbox. Should the Sebi and the MCA greenlight the initiative, companies listed in India would gain the ability to issue shares that could be traded fractionally. Such a shift would necessitate amending pertinent laws and revising the tax structure.

If the proposal goes through, it could simplify investing for individuals with limited savings, fostering more equitable asset allocation. For instance, investing in high-value stocks like MRF or Bosch becomes challenging for retail investors with modest portfolios due to the disproportional weight these shares add. Fractional ownership would mitigate this imbalance, providing more flexibility in diversifying portfolios across sectors.

For perspective, if your total portfolio value is 5 lakh, a single MRF share ( 108,000-plus) would amount to over 20% weight in the portfolio. You might not want that much exposure to a single company in a single industry. But you may for instance, want only 5% exposure to the rubber industry (where MRF is the market-leader) and that’s only possible if you commit a minimum of 20 lakh plus to your equity portfolio. Bosch is trading at above 19,000 and could therefore, present similar problems.

While these are good companies, holding them would skew your portfolio weight undesirably sharply into one sector. 

Institutional investors, often unaffected by these limitations, currently enjoy an advantage over their retail counterparts. 

Typically, financial experts recommend retail investors diversify their portfolios, balancing equity and debt and ensuring exposure to a range of industries for stability through varied business cycles. If you’re young and don’t have many immediate financial commitments, the planner may suggest for instance, that you hold 80% of your financial assets in equity and 20% in debt instruments. Within equity, they would also advise exposure to let’s say 10-15 different companies spread across many industries. That way, whatever the business cycle, something in your portfolio should be doing well.

Every two or three years, you should review and rebalance allocations. If your equity portfolio has ballooned and become 95% of your assets, you need to sell some equity and put the proceeds into debt. High-priced shares make this entire process of asset allocation and rebalancing very unwieldy.

Even if you and your buddies want to buy a single share and divide up the returns and dividends into fractions, the titular owner remains one individual who receives the capital appreciation, and the dividends, and carries the tax exposure. That person’s nominee or heir would inherit as well. Any arrangements you made to create fractional ownership would be unofficial and hard to enforce.

While fractional shares could alleviate these challenges, the MCA's current proposal is poised to be applicable only to new issuances, excluding existing high-valued stocks like MRF. Delving into the proposal's specifics will be crucial, given the intertwined tax, legal inheritance, and company law ramifications, not to mention potential impacts on shareholder voting rights.

Assuming that individuals are allowed to each hold a fraction of a share, and split the dividends if any, and take any subsequent stock splits in that same fractional ratio, and similarly offset inheritances, things would become easier for retail investors. Rebalancing and juggling portfolio weights will become much easier.

In effect, this would work somewhat like a stock split without a formal split. In a stock split, the face-value of an equity share is formally divided – a 10 fv share can become 10 share of 1 FV. If a company issues a bonus, the face value doesn’t change (combination-split-cum-bonuses do take place of course). A proportion of reserves (the accumulated profits of the business) are capitalised, turned into shares and handed over to shareholders in the announced ratios. Companies also have to manipulate share-swap ratios when a merger takes place and again, fractions cause difficulties in reconciliation.

If fractional shares are allowed, this breaking up of share face-value is not needed. Each investor can own a fraction of a single share. This would also result in better price-discovery and more liquidity in high-priced shares.

Learning to think in fractions rather than integers is not too difficult when learning mathematics. It presents more in the way of regulatory difficulties when it comes to company law and taxation but an acceptance of this proposal would give retail investors a more even playing field.

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