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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.

Wireless Firms Act As Utilities; Other Techs Exit Top Rankings

The market faces no shortage of challenges: a buildup of distribution days, the S&P 500 settling back into negative territory for the year, and the Nasdaq diving below support at its converged 50- and 200-day moving averages. Those technical challenges are being underscored by another development: a vacuum of leadership among technology industries. Tech industry groups have entirely exited the top 20 of IBD’s 197 group rankings, with the exception of two: wireless and integrated telecom services. The wireless services group includes major mobile phone carriers Sprint ( S ) and T-Mobile U.S. ( TMUS ). The integrated group is dominated by AT&T ( T ) and Verizon ( VZ ). Investigate this tech stock that broke out of a base in heavy trade on Thursday using IBD’s Stock Checkup feature. Wireless services and networks are clearly high-tech territory. But as more consumers abandon their landlines and rely strictly on wireless services, and as more young people spend a growing share of their lives via smartphones, the wireless stocks also increasingly present the stability associated with utility stocks. In that respect, they represent a defensive hedge for funds and other large investors as indexes weaken. This could help explain why both of the telecom groups rose into the top 20 rankings as the broad market pulled back over the past four weeks. The S&P 500 has backed off 3.7% from its mid-April high. The tech-heavier Nasdaq peeled back 5.3% during the same period. Even 13 weeks ago, when defensive groups such as utilities, bond funds and tobacco crowded the leading ranks, tech groups including Internet content providers, chip equipment makers and solar energy manufacturers held in the top 20 rankings. Instead of continuing to lead the market, those three groups have since fallen to rankings of No. 85, No. 110 and No. 169, respectively. Beyond the top 20 rankings, medical systems manufacturers rank a strong No. 23. The technology-driven group counts Intuitive Surgical ( ISRG ) and Idexx Laboratories ( IDXX ) among its bulwarks. The next tech group bearing some potential growth stocks is the scientific electronic equipment group, ranked No. 41 Thursday. Danaher ( DHR ) and Agilent ( A ) are the strong suits here. The only other tech group in IBD’s top 50 rankings is the foreign telecom services industry, led by China Mobile ( CHL ), Japan’s Nippon Telephone & Telegraph ( NTT ) and London-based Vodafone Group ( VOD ). What about the big-charisma tech names? Apple ( AAPL ) is down 16% from its mid-April high. Alphabet ( GOOGL ) is down 10% and fighting for support at its 200-day line. Facebook ( FB ) is down only 3%, but has erased all gains from its April 28 breakout. A number of other stocks in the group are also keeping their heads up as the market pulls back. Look at WebMD Health ( WBMD ) and Zillow ( Z ), just to name a couple. Sell-offs among China-based plays, including Baidu ( BIDU ), YY Inc. ( YY ) and Momo ( MOMO ) have helped pressure the Internet content group to a No. 167 ranking. Amazon.com’s ( AMZN ) chart remains durable, extended above a buy point. Also in the Internet retailers group, Argentina’s MercadoLibre ( MELI ) is in buy range from a 127.87 buy point, although its fundamentals continue to lag. But sell-offs in the group — particularly among China-based Internet plays including JD.com ( JD ), 58.com ( WUBA ) and Vipshop Holding ( VIPS ) — have helped hold the group to a weak No. 104 ranking.

Junk Bond ETF ANGL Soaring: Will Its Flight Last?

Heightened volatility is driving investors to safe havens, making 2016 the year of the bond market. While long-term bonds are the undisputed winners, the high yield corner has drawn attention over the past three-months on investors’ drive for higher yields and a rebound in oil price. In addition, high-yield spreads have tightened significantly from 8.64 on February 12 to 6.36 currently, as per the BofA Merrill Lynch US High Yield Option-Adjusted Spread , making junk bonds attractive. This suggests that investors are now demanding lower premium than comparable Treasury bonds to compensate for the risk. However, the risk of default is on the rise, dampening the appeal for junk bonds. This is because the resumption of the slide in commodity prices and renewed global growth concerns are weighing on companies’ profits and balance sheets yet again. As per Moody’s Investors Service, global junk bond defaults will accelerate to 5% by the end of November, up from the previous forecast of 4.6% one month ago, and 3.8% in March. Fitch Ratings expects high yield bond defaults to climb to 6% this year from 4.5% last year and touch the highest level since 2000 (read: Junk versus Investment Grade Corporate Bond ETFs ). Given the heightened credit risk and low rate environment, investors thronged the high yield quality fund – VanEck Vectors Fallen Angel High Yield Bond ETF (NYSEARCA: ANGL ) . The fund gained 12.3% in the year-to-date time frame, outperforming the broad bond fund (NYSEARCA: BND ) and junk bond fund (NYSEARCA: JNK ) by wide margins. ANGL in Focus This ETF seeks to track the performance of the BofA Merrill Lynch US Fallen Angel High Yield Index, which focuses on the ‘fallen angel’ bonds. Fallen angel bonds are high yield securities that were once investment grade but have fallen from grace and are now trading as junk bonds. This unique approach gives the portfolio 248 securities that are widely spread across them, with none holding more than 1.65% of assets. The fund has an effective duration of 5.67 years and year to maturity of 9.33. Additionally, the product mainly comprises BB and B rated corporates, which together make up for 85.3% of the asset base. Bonds from energy and material sectors occupy the top two positions with 25.2% and 22.1%, respectively, while financial and communications round off the top four with double-digit allocation (read: all the High Yield Bond ETFs here ). ANGL has amassed $158.7 million in its asset base while trades in moderate volume of 82,000 shares a day on average. It charges a relatively low fee of 40 bps per year from investors and yields 5.20% per annum. Behind The Success of ANGL The fallen angels strategy is immensely successful this year as the number of fallen angels has increased substantially on a series of debt downgrades among energy and material firms – the top two sectors of the ETF. In this regard, Moody’s snatched investment grade ratings from 51 companies and gave them the junk status at the end of the first quarter, up from eight in the fourth quarter and 45 for the whole of 2015. These downgrades have boosted the performance of the ETF as bond price generally rebounds after losing an investment grade rating. Additionally, the rebound in oil prices from the 12-year low reached in mid-February injects further strength into these bonds and the ETF. As a result, fallen angels bonds tend to have lower default rates than their more traditional junk bond counterparts, thus offering better risk-reward profiles. These have a history of outperformance in nine out of the last 12 calendar years, according to Market Vectors. Moreover, the outperformance of ANGL was spurred by its higher average credit quality as about three-fourths of the portfolio carry the upper end rating (BB) of the junk category, leaving just less than 4% to the risky CCC-rated and lower. Link to the original post on Zacks.com