Big Cap Energy at a Low Price

07/14/2009 11:00 am EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

Russel Kinnel, editor of Morningstar FundInvestor, and analyst Bridget B. Hughes say Vanguard’s highly rated energy fund is a good, cheap way to invest in the sector.

Vanguard Energy fund (VGENX) is the cheapest actively managed entrant in the natural resources category and only a tad more expensive than Vanguard Energy ETF (NYSEArca: VDE).

Wellington Management runs the lion’s share of this fund. The firm has one of the largest research staffs. While quantity doesn’t always mean quality, the firm’s strong performance records across varying investing mandates suggest a special research backbone.

And while this sector-specific fund means that a subset of the research staff really drives returns, the collaborative culture at Wellington helps inform fund management’s perspective. Karl Bandtel (with Wellington since 1990) steers more than 90% of the fund’s assets. A second advisor, Vanguard’s Quantitative Equity Group, was added in mid-2005. [Its] portion of assets has fluctuated between roughly 5% and 15% of assets.

Wellington’s stock-picking process is bottom up, with an emphasis on attractive valuations and a long-term investment horizon, but there’s an important overarching thesis here: The world’s non-nationalized energy resources are growing scarcer. Bandtel and Jim Bevilacqua thus spend a lot of time thinking about political risk and geological risk—whereas many of their peers focus more on energy demand and commodity prices.

The implication for the portfolio is Clear: It’s chock-full of the sector’s largest, most diversified companies, giving it one of the category’s biggest average market caps. The management team spends much of its time valuing proven reserves, which results in picks like ExxonMobil (NYSE: XOM) and determining which companies have enduring competitive advantages on the services side, [like] Schlumberger (NYSE: SLB).

There have been benefits of sticking with the larger stocks. The fund has been among the least volatile in its category, because its holdings tend to have more diversified revenue streams. They simply aren’t as responsive to the wild swings in oil prices as other funds’ smaller-cap energy stocks. Another plus: Larger companies pay dividends. That, combined with the fund’s low expense ratio, has contributed to one of the highest dividend yields among diversified, actively managed energy funds.

The fund is likely to lag in robust energy rallies—see its 2007 performance. But over time, the fund has delivered: Its ten-year return is in the top quartile. Its longer-term Morningstar Investor Returns, which estimate how the average investor did in the fund, are even better. That doesn’t mean that big setbacks don’t come from time to time; note its 43% drop in 2008 and 20% fall in 1998.

Although the fund’s latest annual report gives an expense ratio of 0.28%, its current prospectus suggests a higher expense ratio is expected after assets dropped in 2008. But even at 0.32%, it doesn’t represent much of a total-return burden.

[Besides the fund’s] ultralow expense ratios, we also appreciate that [manager] Bandtel has skin in the game; here, he invests between $500,001 and $1,000,000.

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