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The 3 Best Retirement Funds for Your 401(k)

When I think about the best funds for a 401(k), I think of a few traits in particular. A fund should be inexpensive to hold, have diversity in its portfolio, and perhaps invest in higher

Avoid The Franklin Small-Mid Cap Growth Fund (FRSGX)

Each quarter we rank, the 12 investment styles in our Style Ratings For ETFs & Mutual Funds report. For the second quarter of 2016 rankings, we noticed a new trend: in five of the past six quarters, the Mid Cap Growth style has received our Dangerous rating. Within that group, we found a particularly bad fund. Of the five worst funds in this style, one in particular stands out for the high level of its assets under management (AUM). When a low quality fund has low AUM, we are comforted that investors are avoiding the poor fund. But, when a fund has over $3.4 billion AUM and receives our Very Dangerous rating, it’s clear that investors are missing pertinent details. The missing details are deep analysis of the fund’s holdings, which is the backbone of our ETF and Mutual Fund ratings . After all, the performance of a fund’s holdings drive the performance of a fund. As such, Franklin Small-Mid Cap Growth Funds (MUTF: FRSGX ) are in the Danger Zone due to alarmingly poor holdings and excessively high fees. Poor Holdings Makes Outperformance Unlikely The only justification for mutual funds to have higher fees than ETFs is “active” management that leads to out-performance. How can a fund that has significantly worse holdings than its benchmark hope to outperform? Franklin Small-Mid Cap Growth Fund investors are paying higher fees for asset allocation that is much worse than its benchmark, the iShares Russell Mid-Cap Growth ETF (NYSEARCA: IWP ). Per Figure 1, at 49%, Franklin Small-Mid Cap Growth Fund allocates more capital to Dangerous-or-worse rated stocks than IWP at just 32%. On the flip side, IWP allocates more (at 19% of its portfolio) to Attractive-or-better rated stocks than FRSGX at only 7%. Figure 1: Franklin Small-Mid Cap Growth Fund Portfolio Asset Allocation Click to enlarge Sources: New Constructs, LLC and company filings Furthermore, 7 of the mutual fund’s top 10 holdings receive our Dangerous rating and make up over 12% of its portfolio. Two stocks in particular raise enough red flags that we have featured them previously: Constellation Brands (NYSE: STZ ) and Willis Towers Watson (NASDAQ: WLTW ). If Franklin Small-Mid Cap Growth Fund holds worse stocks than IWP, then how can one expect the outperformance required to justify higher fees? Chasing Performance Is Lazy Portfolio Management Franklin Small-Mid Cap Growth Fund managers are allocating to some of the most overvalued stocks in the market. We think the days where investing based on past price performance (or momentum) leads to success have passed for the foreseeable future. Managers have to allocate capital more intelligently, not based on simple cues like momentum. The price-to-economic book value ( PEBV ) ratio for the Russell 2000 (NYSEARCA: IWM ), which includes all small and mid cap stocks, is 3.5. The PEBV ratio for FRSGX is 4.6. This ratio means that the market expects the profits for the Russell 2000 to increase 350% from their current levels versus 460% for FRSGX. Our findings are the same from our discounted cash flow valuation of the fund. The growth appreciation period ( GAP ) is 32 years for the Russell 2000 and 22 years for the S&P 500 – compared to 50 years for FRSGX. In other words, the market expects the stocks held by FRSGX to earn a return on invested capital ( ROIC ) greater than the weighted average cost of capital ( WACC ) for 18 years longer than the stocks in the Russell 2000 and 28 years longer than those in the S&P 500, home of some of the world’s most successful companies. This expectation seems even more out of reach when considering the ROIC of the S&P is 18%, or double the ROIC of stocks held in FRSGX. Significantly higher profit growth expectations are already baked into the valuations of stocks held by FRSGX. Beware Misleading Expense Ratios: This Fund Is Expensive With total annual costs ( TAC ) of 3.36%, FRSGX charges more than 84% of Mid Cap Growth ETFs and mutual funds. Coupled with its poor holdings, high fees make FRSGX even more Dangerous. More details can be seen in Figure 2, which includes the two other classes of the Franklin Small-Mid Cap Growth fund (MUTF: FSMRX ) that receive our Very Dangerous rating. For comparison, the benchmark, IWP charges total annual costs of 0.28%. Figure 2: Franklin Small-Mid Cap Growth Fund Understated Costs Click to enlarge Sources: New Constructs, LLC and company filings. Over a 10-year holding period, the 2.42 percentage point difference between FRSGX’s TAC and its reported expense ratio results in 27% less capital in investors’ pockets. To justify its higher fees, the Franklin Small-Mid Cap Growth Funds (MUTF: FRSIX ) must outperform its benchmark by the following over three years: FRSGX must outperform by 3.1% annually. FRSIX must outperform by 1.71% annually. FSMRX must outperform by 1.15% annually. The expectation for annual out performance gets harder to stomach when you consider how much the fund has underperformed already. In the past five years, FRSGX is down 24%, FRSIX is down 35%, and FSMRX is down 27%. Meanwhile, IWP is up 44% over the same time. Figure 3 has more details. The bottom line is that with such high costs and poor holdings, we think it unwise to invest in the belief that these mutual funds will ever outperform their much cheaper ETF benchmark. Figure 3: Franklin Small-Mid Cap Growth Funds’ 5 Year Return Click to enlarge Sources: New Constructs, LLC and company filings. The Importance of Proper Due Diligence If anything, the analysis above shows that investors might want to withdraw most or all of the $3.4 billion in Franklin Small-Mid Cap Growth Funds and put the money into better funds within the same style. The top rated Mid Cap Growth mutual fund for 2Q16 is Congress Mid Cap Growth Funds (IMIDX and CMIDX). Both classes earn a Very Attractive rating. The fund has only $375 million in AUM and IMIDX and CMIDX charge total annual costs of 0.95% and 1.23% respectively, both less than half of what FRSGX charges. Without analysis into a fund’s holdings, investors risk putting their money in funds that are more likely to underperform, despite having much better options available. Without proper analysis of fund holdings, investors might be overpaying and disappointed with performance. This article originally published here on May 9, 2016. Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Beware Profiteers Masquerading As Activists

Activist investors are supposed to play a critical role in the economy. They identify underperforming managers or conflicts of interest that prevent a company from achieving its potential. A few activist investors genuinely do great things for companies, their employees and investors. There are, however, many more investors that masquerade as activists for shareholders when they are really just looking to create short-term gains for themselves. The first kind of activist can create significant value for your portfolio. The second kind tends to weaken companies in the long-term. It’s no secret we’ve been on the opposite side of Bill Ackman’s Pershing Square Capital on many recent stock picks, such as Herbalife (NYSE: HLF ), Mondelez (NASDAQ: MDLZ ), and, most notably, Valeant Pharmaceuticals (NYSE: VRX ). We believe Ackman typifies the activist behaviors that destroy, rather than create, long-term shareholder value. “Serial Acquirers” Valeant remains one of Ackman’s most prominent (and most value-destructive ) positions. Valeant has a long history of acquiring other drug makers . This serial acquisition strategy looks superficially accretive due to the high-low fallacy , which allows the acquirer to artificially boost earnings per share (EPS), one of Wall Street’s most hallowed metrics. Certain activist investors love serial acquirers because they can create the illusion of growth by indiscriminately acquiring other companies. The illusion is growth in revenues, EBITDA, or non-GAAP metrics that overlook the price paid for the acquiree, which, more often than not, is so high that the real cash flows of the deal are highly negative and dilutive to shareholder value. Case in point, Valeant’s debt has increased from $372 million in 2009 to $30 billion over the last twelve months (TTM). At the same time, its shares outstanding have more than doubled while its economic earnings , the true cash flows available to shareholders, have declined from $93 million in 2009 to -$685 million TTM. Valeant has finally given up on its serial acquirer strategy, but the massive debt load seriously limits the company’s strategic flexibility going forward, and the lack of cash flow from all the deals has it in trouble with its creditors . Figure 1: Increase In Debt And Share Count For Valeant Click to enlarge Sources: New Constructs, LLC and company filings. Activists such as Ackman love to tout the “platform value” of serial acquirers. They claim these companies can unlock value from the companies they acquire through superior management. While it’s true that some companies have this capability [just look at how Disney (NYSE: DIS ) has unlocked the value in Pixar, Marvel, and Lucasfilm], these cases are few and far between. Playing Both Sides Of the Deal Another favorite Ackman strategy involves buying up shares in one company while working to help another company acquire that position. We saw this with both Allergan (NYSE: AGN ) and Zoetis (NYSE: ZTS ), two companies that Ackman bought shares in while working with Valeant on an acquisition. Beware what you hear about companies where an activist is on both side of the deal. They may be more focused on getting a quick win to boost their performance, while long-term shareholders deserve much more. Shareholders would be better off if activists just left the company alone. Since 2012, ZTS has grown after-tax profit ( NOPAT ) by 20% compounded annually and increased its return on invested capital ( ROIC ) from 11% to a top quintile 17%. Pushing the company to accept an offer from a firm such as Valeant, with a history of value destruction, is a disservice to current shareholders not an unlocking of value. On top of that, these acquisition dramas create unnecessary distractions from the important work of running the business. Allergan’s CEO David Pyott told CNBC that fending off Ackman and Valeant was a full-time job . The run-up in Allergan’s shares netted Ackman $2.2 billion, but one has to believe the company would have been better off with the CEO devoting his time to running the company. Financial Engineering The Valeant/Allergan saga is far from the first example of Ackman extracting short-term value from a company while hurting it in the long-term. For another case-study, look at his 2005 investment in Wendy’s (NASDAQ: WEN ). Ackman convinced the fast food chain to refranchise a number of stores, sell off Tim Hortons-its most profitable business-and use the proceeds to buy back over $1 billion in stock. The move delivered short-term gains to shareholders, and Ackman booked a nearly 100% return when he sold his shares soon after during a feud with management. Wendy’s never recovered from the loss of Tim Horton’s. Its credit rating was cut, making it more difficult to fund investment through debt, and buying back all those shares used up resources that could have helped renovate stores and keep the chain competitive with McDonald’s (NYSE: MCD ), where Ackman tried and failed to push through a similar plan. Today, Wendy’s stock price remains mired below its level from before Ackman’s involvement, and the company consistently earns an ROIC near the bottom of its peer group. By focusing on financial maneuvers such as refranchising, spin-offs, and buybacks, Ackman successfully extracted short-term value from the company while hurting long-term shareholders. Bad Corporate Governance From Focus on Non-GAAP Earnings The use of non-GAAP metrics is something we have warned about many times. The biggest issue with non-GAAP metrics is that management has wide discretion to add income or remove expenses, which means they can easily manipulate the non-GAAP metrics. Unfortunately, activist investors gravitate towards firms that highlight their non-GAAP metrics because it becomes easier to hide shareholder destruction in the short-term. Unsurprisingly, Valeant was one of the biggest proponents of non-GAAP metrics. The company’s executives bonuses were tied to a non-GAAP metric they called “Cash EPS” that excluded costs related to acquisitions, as well as stock-based compensation. Valeant is far from the only example of lax corporate governance on non-GAAP issues. Take for example, Jarden Corporation (NYSE: JAH ), a firm Ackman voiced strong support for in May 2015. We put Jarden in the Danger Zone in October 2015 due in part to its use of non-GAAP metrics for executive compensation. As long as the firm pays executives based on “adjusted EPS,” which conveniently removes certain restructuring and acquisitions costs, JAH will continue to destroy shareholder value. Jarden also fits the description of serial acquirer and takeover target when it agreed to a deal with Newell Rubbermaid in December 2015. “Unlocking Value” Misses Opportunities Valeant might be in the news more of late, but one of Ackman’s most high profile positions might be Herbalife , about which he released details in a 342 slide presentation in late 2012. We highlighted the strengths of Herbalife’s business in August 2013 and despite continued criticism, the company continues to counter each of Ackman’s claims, as well as investigations by the SEC. Instead of going to $0/share, as Ackman predicted, HLF increased over 144% in 2013 and remains up over 80% since Ackman first announced his position. We noted the strength of Herbalife’s business in our report and the thesis hasn’t changed. Over the past decade, Herbalife has grown NOPAT by 15% compounded annually and increased its ROIC from 21% to a top quintile 32% over the same timeframe. Best of all, Herbalife remains undervalued. At its current price of $55/share, HLF has a price to economic book value (PEBV) ratio of 1.4. This ratio means that the market expects Herbalife to only grow NOPAT by 30% over the remainder of its corporate life. If Herbalife can grow NOPAT by just 7% compounded annually over the next decade , the stock is worth $80/share today – a 37% upside. Activists Should Play A Positive Role… But They Don’t There is no shortage of targets out for activists that truly want to unlock long-term value. Many companies have misguided executive compensation plans that push management towards acquisitions and other activities that destroy shareholder value. Just look at how misaligned executive compensation plans helped push profitable Men’s Wearhouse (NYSE: TLRD ) into the disastrous acquisition of Jos. A. Bank . Activists have more opportunity than ever to push back against misaligned executive compensation plans. The Dodd-Frank Act in 2010 requires all companies to allow “Say On Pay” votes where shareholders can make their voices heard on executive compensation. We’d love to see activists with the resources to take on big companies make a push to better align executive compensation with long-term shareholder value. We have compelling proof in the form of AutoZone (NYSE: AZO ) that linking executive compensation to ROIC can help companies deliver market-beating returns . Unfortunately, activists seem to be going the opposite direction. Between 2009-2014 , fewer activist campaigns targeted issues surrounding executive compensation and corporate governance. Instead, activists radically increased their demands for buybacks, spin-offs, acquisitions, and other feats of financial engineering. Activists also seem to be taking a short-term on their investments. 84% of all activist investments last less than two years, according to FactSet. The good news? These types of activists have underperformed this year . Ackman has led the pack downward. Even before Valeant dropped 50% in March, his losses in 2015 and 2016 had already erased any gains he made in 2014. Maybe this underperformance will push activists away from the financial engineering and towards more substantive changes that truly benefit shareholders. Until then, don’t listen to activist investors claiming they can unlock value unless they articulate a focus on ROIC and long-term cash flows. Look past the typical noise and focus on fundamentals. Find companies that consistently generate profit, earn a quality return on invested capital, and have a stock price where expectations for future cash flows are low. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.