(PUB) Investing 2016

be again; it has been our choice over Capital Opportunity from the day it launched in November 2004. Since the inception of the Odyssey fund through July 2016, Capital Opportunity has performed admirably, gaining 209.7%, while 500 Index returned 142.7%. However, the Odyssey fund ran circles around both its bigger sibling and the index, returning 315.5%. If that doesn’t convince you that having a smaller asset base can be an advantage, I don’t know what will. Caveats aside, Capital Opportunity remains a top-notch fund and a core holding in both the Growth and Con- servative Growth model portfolios. But frankly, I wish we had the old Capital Opportunity back. Unfortu- nately, PRIMECAP Odyssey Aggressive Growth , which is my (and Dan’s) single largest personal investment, is closed to new investors. I hope you took our advice to buy this fund before the doors shut, but the best way for new inves- tors to access the PRIMECAP team is through PRIMECAP Odyssey Growth (POGRX). Explorer Hold. As I alluded to earlier, Vanguard’s original aggressive small- stock fund, Explorer, is now the poster child for the folly of watered-down, multimanager funds. With seven man- agement teams, 14 portfolio manag- ers and over 700 stocks, there are too many play callers to allow an excep- tional manager to stand out. As Jack Bogle, who started the multimanager trend, has said, “Everyone knows that if you have multiple managers, you end up with index-like performance.” Unfortunately, as the relative perfor- mance chart comparing Explorer and the Russell 2500 Growth Index on page 14 shows, Explorer hasn’t even provided index-like returns for over a decade. And the constant manager changes haven’t helped. Explorer probably won’t hurt you too much, but I don’t expect performance to leap ahead of peers or SmallCap Growth Index . This hasn’t been a table- pounding aggressive fund for years. Dan and I have long recommended >

financial crisis of 2007–2009—was deeper than that experienced by small- and large-cap stocks, but not by much. And if we look beyond the finan- cial crisis to the other three periods, mid-cap stocks actually experienced smaller drawdowns than their siblings. Additionally, mid-cap stocks tended to recover faster from those declines. So, for fairly significant extra return, investors historically haven’t had to take on much if any extra risk. A sweet spot, indeed. That’s why Dan and I are big fans of mid-caps. Now let’s turn to the funds as we try to balance the long-term appeal of investing in mid-cap stocks against bloated fund sizes and Vanguard’s dedi- cation to the multimanager system. ACTIVELY MANAGED FUNDS Capital Opportunity Buy. As I mentioned above, Capital Opportunity, while still a terrific fund, outgrew its small- and mid-cap britches long ago. The PRIMECAP Management team runs the fund with an eye toward own- ing some smaller stocks, but having bulked up in size, Capital Opportunity has become much more like its larg- er-cap brothers, PRIMECAP and PRIMECAP Core . The median com- pany here has a market size of about $38 billion, versus $64 billion and $54 billion for its siblings. That’s seven times the size of the median stock in S&P MidCap 400 Growth ETF , but half the size of the median company in 500 Index . Despite the creep in size, supe- rior active management and the tilt toward mid-sized companies have been a powerful combination for Capital Opportunity over the years. Since MidCap Index ’s May 1998 incep- tion (which is just a few months after PRIMECAP took over Capital Opportunity) through July 2016, the index fund outpaced its large-cap sibling 500 Index by a wide margin, 428.5% to 168.6%. Leaning toward mid-sized companies has provided a nice tailwind for Capital Opportunity, but it doesn’t fully explain the active fund’s 789.1% return over the same stretch. That extra

return above and beyond the index comes from the PRIMECAP team’s savvy stock picking. The unique structure of the PRIMECAP team also makes the fund more resistant to the headwind of a growing asset base. Each portfolio manager is individually responsible for investing a sleeve, or portion of Capital Opportunity’s portfolio. If one or more of the team focuses on the same stock, so be it—that company gets a larger allocation in the portfolio. This has resulted in the fund’s top-10 holdings consistently soaking up 30% to 40% of assets. And though there are typically 140 or so stocks in the portfolio, each manager may only hold 30 to 40. Though they make their own buy and sell decisions, the team is rowing in the same direction, and looking for companies with the potential for rapid earnings growth, but which are selling at a discount for one or more reasons. This strategy, known as growth-at-a- reasonable-price, or GARP, can mean buying misunderstood companies or companies in an apparent funk before their next big hit. The managers are patient, and confident that if they’ve done their homework properly (and they usually do), when a company’s fortunes turn, the stocks can take off on multiyear runs. Still, no strategy or manager is com- pletely immune to the effects of having more assets to manage. To highlight this point, let’s look at PRIMECAP Odyssey Aggressive Growth (POAGX), which is the fund Capital Opportunity used to be, and probably never will Russell 2000 Max Cumulative Loss -21.7% -18.6% -21.8% Months To Recovery 4 3 3 Black Monday, 1987 Max Cumulative Loss -28.9% -30.2% -35.5% Months To Recovery 18 17 18 Tech Crash, 2000-02 Max Cumulative Loss -49.1% -30.3% -35.1% Months To Recovery 61 14 15 Credit Crisis, 2007-09 Max Cumulative Loss -50.1% -54.2% -52.9% Months To Recovery 43 24 24 Where’s the Extra Risk? Double-Dip Recession, 1981-82 Russell Top 200 Russell MidCap

The Independent Adviser for Vanguard Investors • September 2016 • 13

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