Investing June 29, 2023

Fidelity to Convert More Than $13B of Mutual Funds to ETFs

The Fidelity small cap enhanced index fund was included in nearly 100 defined contribution plans, according to Form 5500 filings.   

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Fidelity Investments will convert six actively managed index mutual funds—$13.5 billion in total assets, as of April 30—into equity exchange-traded funds, effective November 17, 2023, the firm disclosed in a securities filing Wednesday.

Each of the six and the corresponding new ETFs will have identical investment objectives, fundamental investment policies and principal investment strategies, according to the filing.  

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The Fidelity small-cap fund was in 90 employer-sponsored 401(k) and 403(b) retirement plans—two multiple employer plans—as of year-end 2021, BrightScope data shows. The plans comprise 340,416 total participants, 240,047 active participants and 301,547 with account balances, as of the most recent Form 5500 data analyzed by BrightScope.

Assets under administration for the 90 defined contribution plans that include the Fidelity small-cap fund—including the Fidelity Retirement Savings Plan, totaled $50,539,604,782, as of year-end 2021 according to BrightScope data.  

“If you hold your fund shares through an IRA [individual retirement account] or group retirement plan whose plan sponsor does not have the ability to hold shares of ETFs on its platform, you may need to redeem your shares prior to the conversion, or your broker or intermediary may transfer your investment in the fund to a different investment option prior to or at the time of the conversion,” the filing says.

The tax benefit for ETFs is generally superior than for mutual funds because ETF transactions, generally, do not create a taxable event. 

The benefits of ETFs are lessened, when the investment vehicle is used in the confines of a tax-deferred retirement account, because plans can’t necessarily intraday-trade the ETF of the 401(k) platform either, says Robert Massa, managing director and Houston operations retirement practice leader at Qualified Plan Advisers.

The fiduciary spillover effects to nonprofit and corporate retirement plans are significant, Massa says.

“As a fiduciary you’ve got two things to think about: First of all, [for] a 403(b) plan, you have no choice you [have] to replace the fund—either you’re going to find a like fund, to map it onto an existing fund in the menu—but you’ve got to make this fiduciary decision and get that taken care of before this happens in November.”

“If you’re a 401(k) and let’s say you have a brokerage account option that you offer employees … you might have an ability to offer employees to open the brokerage account and move it in there,” Massa says.

The following funds will be converted:

  • Fidelity International Enhanced Index Fund (FIENX), $1.62 billion in assets will become Fidelity Enhanced International ETF
  • Fidelity Large Cap Core Enhanced Index Fund (FLCEX), $1.86 billion in assets will become Fidelity Enhanced Large Cap Core ETF
  • Fidelity Large Cap Growth Enhanced Index Fund (FLGEX), $2.30 billion in assets will become Fidelity Enhanced Large Cap Growth ETF
  • Fidelity Large Cap Value Enhanced Index Fund (FLVEX), $5.22 billion will become Fidelity Enhanced Large Cap Value ETF
  • Fidelity Mid Cap Enhanced Index Fund (FMEIX), 1.69 billion in assets will become Fidelity Enhanced Mid Cap ETF; and
  • Fidelity Small Cap Enhanced Index Fund (FCPEX), $532.26 million will become Fidelity® Enhanced Small Cap ETF

Fidelity is converting the funds for greater tax efficiency in the securities lending business not for ease of use for the funds by corporate or nonprofit retirement plan sponsors or to lower the fees, says Massa.

Driving Fidelity is cost efficiency in the securities lending business, lowering “unnecessary” taxable income, he explains. “There’s a certain amount of practicality to it [because here] it’s essentially an enhanced index, which makes some money from securities lending.”

Corporate and nonprofit retirement plans must address how to proceed, because ETFs cannot be accommodated by most retirement plans’ recordkeeping systems, he adds.

“If it’s in my [corporate retirement plan] core fund menu, I can’t hold it as an ETF,” Massa says. “That’s not 100% true and it’s not universally true but it’s largely true, because what [a retirement plan would] end up having to do is unitizing the portfolio and unitizing the ETF is no different—like unitizing company stock—there’s [big] such costs in doing it, [that] it loses all the benefit of the ETF. So why would you do it?”

Fidelity is making the conversion to remain an innovator in the ETF space, says a spokesperson, via email.

“We continue to look for opportunities to grow our lineup with innovative strategies that help meet the evolving needs of investors,” the Fidelity spokesperson says. “These conversions deliver new opportunities and value for our existing shareholders, while also expanding our solutions to help meet demand for access to innovative strategies in an ETF wrapper.”

Fidelity plans to lower the costs of each fund, the filling says.

“Fidelity believes that the conversion will provide multiple benefits for investors of the funds, including lower expenses, additional trading flexibility, increased portfolio holdings transparency and the potential for enhanced tax efficiency,” according to the filing.

At a meeting on June 14, the Board of Trustees of Fidelity Commonwealth Trust approved on behalf of the fund, the reorganization of the funds into ETFs, the filing shows. 

With the conversions, shareholders of the funds will receive ETF shares equal in value to the number of shares of the fund they own and may receive a cash payment instead of fractional shares of the ETF, and the redemption of fractional shares may be a taxable event, says the filing.   

The low-cost of ETFs compared to mutual funds appeals to Millennial investors, particularly in allocations to self-directed brokerage window accounts. Despite cost pressure to lower retirement plan fees generally and excessive fee lawsuits a significant basis for retirement plan litigation, ETFs have not been widely accepted by defined contribution plan sponsors.   

“Importantly, to receive shares of an ETF as part of the conversion, fund shareholders must hold their shares through an account that can hold shares of an ETF (i.e., a brokerage account). If fund shareholders do not hold their shares through an account that can hold shares of an ETF, they will not receive shares of an ETF as part of a conversion,” says the filing.

There are a variety of reasons why ETFs have not made greater inroads to retirement plans that include recordkeeping hurdles and fiduciary concerns about plans allowing intra-day trading. Another reason that has been noted in the past about why ETFs have not been popular in retirement plans  is that the majority of assets in defined contribution plans are invested with legacy recordkeeping platforms that were built with the assumption that only mutual funds were available. 

“None of our clients utilize these funds being converted,” said Craig Stanley, lead partner, retirement plan consulting, at Summit Group 401(k) Consulting, an Alera Group Company. 

He explains that for plan sponsors with recordkeeping systems accommodating ETFs may not be comfortable, “adding anything that would potentially encourage participants to trade more frequently within their 401(k) accounts with their retirement savings [because it] goes against many long-term investing fundamentals that advisers have tried to instill.”  

Compliance June 28, 2023

House Republicans Call for More Transparency in ESG and Proxy Voting

Republicans focus on the environmental aspect of ESG in a recently published report on Republican policy goals concerning investor activism.

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An “ESG Working Group” established by Republicans on the House Committee on Financial Services in February, published an interim report, June 23, highlighting the various policy goals it intends to pursue. These include: regulating proxy voting and environmental, social and governance rating firms, mitigating application of European Union regulations to U.S. issuers, and blocking the Securities and Exchange Commission’s climate disclosure proposal.

The report indicates that the group is primarily interested in the “E” for environmental in the ESG moniker, a focus that is reflected in the lawsuits brought by fossil fuel industry groups seeking to overturn the Department of Labor’s Employee Benefits Security Administration’s rule proposal permitting ESG factors to be used by fiduciaries making retirement plan investment decisions: “The initial focus of the Working Group centers on the environmental aspect, specifically the current promotion of environmental policies in the financial services industry and by regulatory bodies.”

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To that end, the group recommended reforms to the proxy voting industry. They identify the two largest proxy voting firms, Glass Lewis and Institutional Shareholder Services Inc., which is the parent company of PLANSPONSOR. The House group states that proxy voting firms need to be more accountable and transparent to shareholders, including being required to publish their methodologies and data regularly and only considering pecuniary factors in making their voting recommendations. Additionally, the report says  proxy voting firms should be required to disclose whether any of the proposals on which they are offering a voting recommendation was submitted by a client, so as to reduce conflicts of interest.

The report makes broadly similar recommendations for ESG ratings firms (ISS also provides ESG ratings). The House members write that firms selling ESG ratings should disclose their methodologies and data used in assigning the ratings.

The group also identifies the volume and content of some shareholder proposals as a problem. They argue that shareholders submit too many politically motivated proposals that consume time and resources for issuers. They state that the SEC should make it harder to submit and resubmit previously denied proposals by increasing the ownership thresholds for making proposals to enable shareholders to submit a proxy proposal if they have owned $2,000 of the company’s securities for at least three years; $15,000 of the company’s securities for at least two years; or $25,000 of the securities for at least one year.

The SEC’s current proposal on climate disclosure should not be allowed to proceed, the group argued. It said that the proposal goes beyond the SEC’s authority to require climate-risk and greenhouse gas disclosure because these are not material concerns, and accuses the SEC of prioritizing “social justice” over investment returns.

The largest asset managers were also a target of the report. The “Big Three,” or The Vanguard Group, BlackRock and State Street Global Advisors, were identified by the group as posturing as passive investors that are actually quite active in voting to approve ESG and diversity, equity and inclusion initiatives. The report criticizes the firms for having signed an international net zero commitment, which Vanguard left at the end of 2022. The report says, “Congress should consider policies that better align the voting behavior of passively managed index funds with retail investors’ best interests.”

Lastly, the report argues that the U.S. government should be more active in advocating for U.S. securities issuers in the context of foreign regulations. The report specifically identifies the EU’s Corporate Sustainability Due Diligence Directive, which requires issuers with more than $150 million in market capitalization to disclose scope 3 emissions, referring to the carbon emissions of firms within a company’s supply chain, but not the company itself. The regulation applies to many U.S.-based issuers operating in the EU, and the group argued that the U.S. government should negotiate with foreign jurisdictions to remove or mitigate the applicability of foreign regulations to U.S. businesses.

 

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