Primecap's Best Practices

Morningstar has long emphasized the importance of stewardship in evaluating mutual funds. We began assigning  Morningstar Stewardship Grades for funds to the largest fund families a decade ago, and we use the same methodology for the Parent pillar that goes into the Morningstar Analyst Ratings for all the funds we cover. These grades favor firms that stay out of trouble and put fund shareholders first.

In a recent Morningstar study, my colleagues Bridget Hughes, Laura Lutton, and Christina West surveyed the U.S. fund industry and found that positive stewardship features--strong fund manager tenure and retention, high manager ownership of fund shares, and low fees--are associated with better long-term returns. They also looked at the same features for the 20 largest U.S. fund firms by assets, showing how those features are correlated with high fund stewardship grades.

Primecap Management doesn't have a full stewardship grade because it's not among the 20 largest fund firms, but in many ways it's a model steward, exemplifying a lot of the best practices that we like to see. Primecap subadvises  Vanguard Primecap (VPMCX),  Vanguard Primecap Core (VPCCX), and  Vanguard Capital Opportunity (VHCOX) and advises the three Primecap Odyssey funds:  Primecap Odyssey Growth (POGRX),  Primecap Odyssey Stock (POSKX), and  Primecap Odyssey Aggressive Growth (POAGX). (Full disclosure: I have been a shareholder of Vanguard Primecap since 1994 and still have my entire Roth IRA invested in it.) The firm lost two of its co-founders and co-portfolio managers in recent years, when Howard Schow died in April 2012 and Mitch Milias retired at the end of 2013. But it has handled this transition well, and we recently reaffirmed its positive Parent rating. It's worth taking a closer look at what makes this fund family so special.

First of all, Primecap looks excellent according to the quantitative measures that went into our recent study. One such measure is manager investment. Managers who invest in their own funds align their interests with those of shareholders, and our research has shown that higher manager ownership is correlated with better long-term performance. Of the four Primecap managers, three have more than $1 million invested in each of the six funds they manage, an impressive level of commitment. The fourth manager, Mohsin Ansari, "only" has $100,000 to $500,000 in each of the six funds, but he has only been a listed manager of the funds for a few years, and his investment has steadily increased since then.

Fees are another measure where Primecap really shines. The three Vanguard funds subadvised by Primecap have long featured impressively low expenses, as one would expect from Vanguard, and Primecap has followed suit with its own funds. When Primecap launched the Odyssey funds in late 2004, it capped the expense ratios at 1.25%, but those expenses rapidly came down over the next couple of years as the funds' asset bases grew. The Primecap Odyssey funds are all among the cheapest 20% of their peer groups, with no sales loads or 12b-1 fees; Primecap Odyssey Growth costs 0.65%, Primecap Odyssey Stock costs 0.63%, and Primecap Odyssey Aggressive Growth costs 0.64%.

At first glance, Primecap doesn't look quite as good as some of its peers in terms of manager tenure, simply because the Primecap Odyssey funds, which form the basis of its Parent rating, have been around for less than 10 years. Its five-year manager-retention rate is also less than 100% because of the departure of Schow and Milias. But the team has been very stable over the years, and the four remaining managers are an experienced lot. Theo Kolokotrones co-founded the firm and has been a named manager on Vanguard Primecap since 1985; Joel Fried has been with the firm since 1986 and a comanager since 1988; and Al Mordecai has been a comanager since 1999. The relative newcomer is Ansari, who was named comanager of the Vanguard funds in October 2010 and the Primecap Odyssey funds in April 2012 after Schow's death, but he had been managing slices of the funds long before that and has been with the firm since 2000.

All these elements are related to a feature of Primecap that's less quantifiable but no less attractive, namely its corporate culture. Unlike fund shops that are relatively small parts of sprawling financial conglomerates, Primecap is devoted entirely to managing money, and the bulk of that money (about $71 billion out of $87 billion as of April 2014) is in its mutual funds. The management team focuses on fundamentals and takes a long-term perspective, looking for stocks that are temporarily out of favor but still have great long-term growth potential. It's very much a team-based approach, in which each team member separately manages a sleeve of the portfolio, and there are no star managers. In fact, the Primecap managers have almost entirely avoided publicity, so that you probably couldn't pick any of them out of a lineup.

This team-based culture is why the funds hardly skipped a beat with the death of Schow and the retirement of Milias. Those managers' assets were distributed among other members of the team, including Ansari and some senior analysts who had already been managing some assets. Primecap takes years to train its analysts and steep them in its investment culture. Analysts will often get a sleeve of assets to run within the sector they specialize in, and if they do well with that, they'll get to manage a diversified sleeve and eventually run larger slices of the team's various portfolios.

All of this would be academic if the Primecap funds had mediocre track records, but in fact they've achieved some of the best long-term returns in the industry. Vanguard Primecap and Vanguard Capital Opportunity both rank in the large-growth category's top 5% over the trailing 10 and 15 years, and the other four funds (all of which were launched in late 2004) rank near the top of their respective peer groups since inception. Several of the funds have gone through slow stretches in recent years, but all of them put up strong results in 2013, with Vanguard Capital Opportunity and Primecap Odyssey Aggressive Growth ranking in the top decile of their categories (large growth and mid-cap growth, respectively). These funds provide a great illustration of how topnotch performance can go hand in hand with exemplary stewardship and respect for shareholders.