Vanguard PRIMECAP Fund: An Active Fund Endorsed by an Index Fund King

In 1984, Vanguard's founder, John Bogle, seeded the Vanguard PRIMECAP Fund with $100,000 of his own money. Over the following three decades, the actively managed Vanguard PRIMECAP Fund would turn his original investment into more than $5.5 million, or twice what it would have become if it were invested in the S&P 500.

Its record of topping the market's return has persisted to this day. The Vanguard PRIMECAP Fund beat the S&P 500 by an average of 3 percentage points per year over the last 15 years with its stockpickers' simple strategy of buying out-of-favor growth companies and holding them for a decade, if not longer. 

Image source: Getty Images.

Data source: Vanguard.

The recipe is simple: PRIMECAP hopes to identify companies that have good growth prospects, but cheap shares because of temporary stumbles. By keeping expenses low -- the fund is significantly less expensive than the average actively managed mutual fund -- more of its returns make their way to its investors' pockets.

The firm behind the fund

Vanguard PRIMECAP is a Vanguard fund in name only. It isn't an index fund like most of Vanguard's funds, nor is it managed by Vanguard. The fund is run by PRIMECAP Management, a firm that Barron's once called "one of the best shops you've never heard of."

In terms of assets under management, PRIMECAP Management is one of the largest asset managers in the United States, with about $102 billion of managed money, according to recent regulatory filings. But it isn't a big operation run out of a Manhattan skyscraper. The firm employs only 36 people in its Los Angeles office. Only 16 of its employees are responsible for investment advisory and research functions (stockpicking).

Having fewer cooks in the kitchen seems to be an asset rather than a liability. The company takes a multi-manager approach in which five individual portfolio managers are responsible for investing a portion, or "sleeve" of a fund's assets. Managers tend to invest for the long haul. The fund's turnover ratio was just 9% last year, which imputes an average holding period of 11 years for individual stock holdings.

The firm's preference for growth stocks and long holding periods is a function of culture. Howard Schow founded PRIMECAP in 1983 with two others who he worked with at Capital Group, an asset manager that is best known for its Growth Fund of America, a growth stock mutual fund that had a record of beating the market by buying growth stocks and holding for the long haul.

The investment portfolio

Because the fund's assets are divided and run by multiple managers, the fund's portfolio is frequently overweight some sectors while massively underweight others. The fund benchmarks its performance relative to the S&P 500. But an S&P 500 tracker fund this is not!

Technology and healthcare stocks are a staple of the Vanguard PRIMECAP Fund, making up about 54% of the fund on a combined basis, and 17% and 14% more of the fund than their weightings in the S&P 500 index, respectively. The fund shies away from financial services and consumer staples stocks, industries that typically have less earnings growth potential.

Naturally, the short-term performance of the Vanguard PRIMECAP Fund will be largely driven by the performance of technology and healthcare stocks relative to other industries. The fund has underperformed the S&P 500 in six of the last 15 years, though it handily topped the index over the full 15-year period, returning 10.3% compared to the index's 7.3% annualized returns.

Funds that concentrate their portfolios in individual stocks and sectors will naturally post short-term returns that can deviate significantly from the stock market average. The Vanguard PRIMECAP Fund is no exception.

Take a number

The success of the Vanguard PRIMECAP fund means that it is frequently closed to new investors, as is currently the case. The California-based asset manager also runs the Vanguard Capital Opportunity Fund (VHCOX -1.00%) as well as the Vanguard PRIMECAP Core Fund (VPCCX -0.55%), which are also closed.

But all hope is not lost for investing in a PRIMECAP-managed fund; you'll simply have to go straight to the source.

The PRIMECAP Odyssey Growth Fund (POGRX -0.90%) has a return profile that is closest to the Vanguard PRIMECAP Fund. It is a different fund, carrying a higher expense ratio of 0.64% compared to the 0.34% expense ratio of Vanguard PRIMECAP Fund's Admiral Shares.

Like the Vanguard PRIMECAP Fund, the PRIMECAP Odyssey Growth Fund has some quirks in how it allocates assets. Technology and healthcare companies make up a whopping 64% of assets, and it almost completely ignores real estate, utilities, and communication companies. After all, the same people who manage the Vanguard PRIMECAP Fund also manage the Odyssey Growth Fund.

Returns are solidly in the upper-quintile for funds in its category over periods spanning from one to 10 years, but keep in mind that the fund does take a little extra risk. The Odyssey Growth Fund holds about 44% of its assets in companies that are mid cap-sized or smaller compared to Vanguard's PRIMECAP Fund, which holds 8% of its assets in small and mid cap stocks.

Ultimately, as with any actively managed fund, it's the management that really matters. Few managers have a record that looks anything like PRIMECAP's, and with fees that are more than reasonable on all of its funds (Vanguard and non-Vanguard alike), even the most ardent fans of low-cost index funds could be tempted to bet on what has been a very good jockey.