UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT
OF
REGISTERED MANAGEMENT INVESTMENT COMPANIES

Investment Company Act file number: 811-3916

Name of Registrant: Vanguard Specialized Funds

Address of Registrant:
P.O. Box 2600
Valley Forge, PA 19482

Name and address of agent for service:
Heidi Stam, Esquire
P.O. Box 876
Valley Forge, PA 19482

Registrant’s telephone number, including area code: (610) 669-1000

Date of fiscal year end: January 31

Date of reporting period: February 1, 2010 – January 31, 2011

Item 1: Reports to Shareholders

 

 

 

 

> Helped by rising energy prices, Vanguard Energy Fund returned about 27% for the fiscal year ended January 31, 2011.

> The Energy Fund’s return slightly lagged that of its benchmark index but was ahead of the average return of peer-group funds that invest in energy and other natural resources.

> Oil and gas equipment and services providers posted exceptionally strong results, while giant integrated oil and gas companies were responsible for nearly half of the fund’s total return.

 

Please note: The opinions expressed in this report are just that—informed opinions. They should not be considered promises or advice. Also, please keep in mind that the information and opinions cover the period through the date on the front of this report. Of course, the risks of investing in your fund are spelled out in the prospectus.

See the Glossary for definitions of investment terms used in this report.

Cover photograph: Jean Maher.

 

Your Fund’s Total Returns

Fiscal Year Ended January 31, 2011

Spliced Energy Index: S&P 500 Index through November 30, 2000; S&P Energy Sector Index through May 31, 2010; MSCI All Country World Energy Index thereafter.
Global Natural Resources Funds Average: Derived from data provided by Lipper Inc.
Admiral Shares carry lower expenses and are available to investors who meet certain account-balance requirements.

Your Fund’s Performance at a Glance
January 31, 2010 , Through January 31, 2011

 

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Chairman’s Letter

Dear Shareholder,

Despite the huge oil spill involving British oil giant BP, energy was one of the stock market’s better-performing sectors for the fiscal year ended January 31, 2011. Vanguard Energy Fund returned about 27% for the period, trailing its benchmark index but ahead of its broader natural resources peer group.

The oil spill did hinder performance, especially during the fiscal year’s first half, but a rally in oil prices led to solid gains over the final months. Stock selection among oil and gas equipment and services providers boosted the fund’s returns. However, selection among integrated oil and gas companies didn’t measure up as well against the spliced benchmark index. Benchmark comparisons may be distorted by the fund’s change from an all-U.S. to a more global benchmark on June 1.

If you invest in the Energy Fund through a taxable account, you may wish to review information about the fund’s after-tax performance provided later in this report.

Also, please note that on October 6 Vanguard broadened the availability of our lower-cost Admiral Shares. We reduced the Admiral minimums on most of our actively managed funds, including the Energy Fund, to $50,000 from $100,000, as part of our ongoing efforts to lower the cost of investing for our clients.

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Stocks rallied as economy ground into gear
Global stock markets produced excellent returns in the year ended January 31, 2011, with much of the strength materializing in the second half of the year. Europe’s sovereign debt challenges and concerns that the economic recovery in the United States might not reach escape velocity seemed to recede from investors’ minds, displaced by strong corporate earnings and a powerful rebound in consumer spending and in the manufacturing sector.

The U.S. stock market returned about 24%. Small- and mid-capitalization stocks, often the first to respond to changes in the economic outlook, did even better. As a group, non-U.S. stock markets returned more than 18%. Emerging markets were the best performers. Despite high-profile dramas in Europe’s government bond markets, European stocks produced double-digit gains. Asia’s developed markets turned in mixed results on local exchanges, but the strength of the yen, the Australian dollar, and other regional currencies bolstered returns for U.S.-based investors.

A strong start, a faltering finish for bonds
In January 2010, the bond market’s near-term prospects looked dubious, in large part because yields hovered near generational lows. Over the following 12 months, however, yields dipped lower still. The taxable bond market returned about 5% for the year. As investors searched for yield, corporate bonds produced the best returns, with the riskiest credits leading the market.

Market Barometer

 

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Toward the end of the fiscal year, an improving economic outlook nudged interest rates higher, putting pressure on bond prices. This dynamic was evident in the municipal bond market, where rising rates and a confluence of other factors weighed on prices. The expiration of the Build America Bonds program, for example, raised the prospect of a spike in new tax-exempt issuance, while the extension of federal tax rate cuts that were set to expire made munis’ tax exemption somewhat less attractive. For the full year, the muni market returned about 1%.

As it has since December 2008, the Federal Reserve held its target for short-term interest rates near 0%, keeping the returns available from money market instruments such as the 3-month Treasury bill in the same neighborhood.

Rising oil, commodity prices helped offset BP’s problems
Vanguard Energy Fund soared 20% over the final three months of the fiscal year, overcoming a rocky stretch related in large part to the BP oil disaster and the effect it had on the industry. The fund benefited from a rise in crude oil prices and from firming demand for oil and most other energy sources.

Oil and gas equipment and services providers were among the companies that received a lift from rising oil prices. Though drilling was curtailed in the Gulf of Mexico after the BP oil disaster, deepwater drilling continued unabated in other locations around the world. Standouts included Halliburton and Baker Hughes, both of which had larger weightings in the fund than in the index.

Expense Ratios
Your Fund Compared With Its Peer Group

The fund expense ratios shown are from the prospectus dated September 30, 2010, and represent estimated costs for the current fiscal year.
For the fiscal year ended January 31, 2011, the fund’s expense ratios were 0.34% for Investor Shares and 0.28% for Admiral Shares. The peer-group expense ratio is derived from data provided by Lipper Inc. and captures information through year-end 2010.

Peer group: Global Natural Resources Funds.

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But oil wasn’t the only energy source driving returns. Favorable stock selection among other commodity-oriented companies also proved to be a tailwind for the fund. Increased demand for coal sparked coal behemoth Peabody Energy, while rising uranium prices helped Cameco Corporation, the huge uranium miner.

While commodity prices were generally higher, natural gas was an exception. The available supply of natural gas increased significantly as horizontal drilling and hydraulic fracturing (“fracking”) was used more to extract natural gas from shale formations. Demand hasn’t kept up with this increased supply. For example, EOG Resources, a horizontal driller that had a larger weighting in the fund than in the index, returned more than 18%—but was outpaced by some other companies in better-performing areas.

Of course, a review of the Energy Fund wouldn’t be complete without considering BP, which dominated the headlines over the past year. The stock remained one of the fund’s top ten holdings and ultimately shaved more than a percentage point from its return. Although BP returned about –14% for the fiscal year, it rebounded from more dramatic lows once the spill was contained.

The fund’s long-term record shines brightly against peers
The Energy Fund’s long-term numbers are impressive, whether measured against the fund’s comparative standards or against the

Total Returns
Ten Years Ended January 31, 2011

Spliced Energy Index: S&P 500 Index through November 30, 2000; S&P Energy Sector Index through May 31, 2010; MSCI All Country World Energy Index thereafter.
Global Natural Resources Funds Average: Derived from data provided by Lipper Inc.

The figures shown represent past performance, which is not a guarantee of future results. (Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance.) Note, too, that both investment returns and principal value can fluctuate widely, so an investor’s shares, when sold, could be worth more or less than their original cost.

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broad U.S. stock market. Over the last decade, the fund’s Investor Shares had an average annual return of 15.39%, handily surpassing both its benchmark index and its peer group. The broad U.S. stock market (as measured by the Dow Jones Total Stock Market Index), which encountered two difficult bear markets during this decade, posted an average annual return of 2.47% for the ten years.

Please be aware that a notable rise in energy prices over the decade powered the fund’s ascent. Such favorable conditions won’t always be present, but the fund’s advisors, Wellington Management Company, llp, and Vanguard Quantitative Equity Group, also deserve a nod for the fund’s performance. Both firms employ disciplined, value-conscious investment strategies, but in different ways. Wellington conducts rigorous bottom-up research to find stocks it deems undervalued, while the Quantitative Equity Group relies on a computer-based approach to evaluate and rank stocks. The fund’s low costs are also a valuable advantage, allowing investors to keep more of the returns.

For more details on the advisors’ strategies and the fund’s positioning during the year, see the Advisors’ Report that follows this letter.

Sector funds can round out a well-balanced portfolio
While energy stocks finished the fiscal year with healthy gains, the course they followed was bumpy at times. With any single sector or market niche, the chance for turbulence is high. In this case, the fallout from the BP oil spill spread throughout the sector and limited returns before more positive industry developments interceded.

There’s no crystal ball to reveal where the stock market and the energy sector are headed. That’s why Vanguard encourages investors to maintain a balanced allocation of assets among stock, bond, and money market funds, diversified within each of these asset classes. Such a portfolio should be consistent with your investment objectives, risk tolerance, and time horizon.

Vanguard Energy Fund, with its low-cost exposure to a major segment of the global economy, can serve as an important element in a diversified portfolio as you strive to meet your financial goals.

As always, thank you for entrusting your assets to Vanguard.

Sincerely,

F. William McNabb III
Chairman and Chief Executive Officer
February 9, 2011

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Advisors’ Report

The Investor Shares of Vanguard Energy Fund returned 27.17% (Admiral Shares, 27.24%) for the fiscal year ended January 31, 2011. Your fund is managed by two advisors, a strategy that enhances the fund’s diversification by providing exposure to distinct, yet complementary, investment approaches. It’s not uncommon for different advisors to have different views about individual securities or the broader investment environment.

The advisors, the amount and percentage of fund assets each manages, and brief descriptions of their investment strategies are presented in the table below. The advisors have also provided a discussion of the investment environment that existed during the year and of how their portfolio positioning reflects this assessment. These reports were prepared on February 16, 2011.

Wellington Management Company, LLP

Portfolio Manager:
Karl E. Bandtel, Senior Vice President

Investment environment
Global equities continued their ascent, driven by investors’ enthusiasm for additional government debt purchases by the U.S. Federal Reserve, the extension of tax cuts in the United States, strong earnings growth, and generally improving economic data. In the energy sector, a

Vanguard Energy Fund Investment Advisors

 

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substantial portion of the period was dominated by the Deepwater Horizon disaster in the Gulf of Mexico.

Crude oil prices remained range-bound for much of the fiscal year as strong demand from emerging markets was tempered by large stockpiles in the developed world. Near the end of the period, rebounding manufacturing demand chipped away at inventories; this, along with concerns about possible disruptions to supply amid uncertainty in Egypt and other areas of the Middle East, sent oil prices to two-year highs. West Texas Intermediate crude oil closed the fiscal year at $92 per barrel.

The natural gas markets were weak throughout the fiscal year, with prices holding at relatively low levels, mainly because of burgeoning North American shale production. Natural gas (Henry Hub) closed the period near $4.40 per million BTUs.

Our position in Chevron, a leading integrated oil and gas company, contributed to the portfolio’s performance during the period. Chevron is well-positioned relative to its peers, given its leverage to oil and its strong recent track record of production growth and upstream profitability. The recently announced acquisition of Atlas Energy gives the firm acreage in one of the best shale plays at a reasonable cost.

During the latter part of the period, higher oil prices and expanding offshore rig fleets led energy equipment and services holdings higher, some of which we trimmed. Baker Hughes, an oilfield services company, was among the top absolute contributors to our portfolio’s performance as earnings exceeded expectations on the back of revenue improvement, cost-cutting, and gains in market share.

Our position in BP, which skidded lower in the aftermath of April’s oil spill, was an absolute detractor during the period. We added to our position during the months following the spill as the market continued to punish the stock further. While the disaster has been costly for BP, it will, in our view, ultimately prove manageable for the company.

Even though our long-term outlook is positive, we would urge some degree of caution regarding the near-term direction of commodity prices.

We have replaced some of our energy equipment and services positions with holdings more closely tied to oil production, particularly those of the integrated oil companies. We initiated a new position in INPEX, a Japan-based company engaged in the exploration and development of natural resources. The firm has a solid production outlook and potential upside from a large, undeveloped offshore liquefied natural gas project near Western Australia.

The portfolio remains focused upstream and skewed in favor of low-cost producers with compelling valuations based on our

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assessment of their respective long-term resource bases. We believe many of these companies have the ability to create value absent generally rising commodity prices.

Our investment process remains steady, with an emphasis on high-quality management and long-lived resources at reasonable valuations. Maintaining a large-cap, low-turnover bias, this global portfolio continues to be diversified across energy subsectors and to focus on big integrated oil companies.

Vanguard Quantitative Equity Group

Portfolio Manager:
James D. Troyer, CFA, Principal

In a year when volatility continued to contribute to market uncertainty, global energy stocks generally finished with a strong second half after underperforming the broad global market during the first six months. North American and Asian energy stocks led the pack, while emerging market firms started the year strong but then declined, and European stocks never fully recovered from the declines associated with the BP oil spill in April.

Despite the turbulence in the energy sector over the period, our model held up well. A key characteristic of our strategy is that we do not maintain a view on the overall market for energy shares. Nor do we attempt to make calls on relative country performance. Rather, our investment process seeks to identify stocks that we believe are undervalued or whose prices have responded favorably to recent earnings announcements, relative to their peers in the sector. Our risk-control process then helps us neutralize our exposure to market-capitalization, volatility, and industry risks relative to our spliced energy benchmark. In our view, such risk exposures are not justified by the rewards available.

For the period, our most successful holdings were spread throughout the globe—including ConocoPhillips (+55%), National-Oilwell (+82%), and Cimarex Energy (+112%) in the United States; Royal Dutch Shell (+38%) in Europe; and CNOOC Limited (+60%) in Asia. Equally important was our ability to limit our exposure to underperforming stocks such as Brazil’s Petroleo Brasileiro (–9%) and U.S.-based Patterson-UTI Energy (–17%).

In addition to the negative effect seen from holdings in BP, our portfolio’s results were dampened by overweight holdings in Encana and Trican Well Service, two Canadian energy stocks that under-performed the benchmark as a whole.

Looking forward, we believe our approach to constructing a portfolio with stocks that exhibit lower valuations than peers, with similar expected growth prospects, is an attractive strategy, one that the market will reward in the long term. We thank you for your investment and look forward to the upcoming year.

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Energy Fund

Fund Profile
As of January 31, 2011

 

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Energy Fund

 

 

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Energy Fund

Performance Summary

All of the returns in this report represent past performance, which is not a guarantee of future results that may be achieved by the fund. (Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance.) Note, too, that both investment returns and principal value can fluctuate widely, so an investor’s shares, when sold, could be worth more or less than their original cost. The returns shown do not reflect taxes that a shareholder would pay on fund distributions or on the sale of fund shares.

Cumulative Performance: January 31, 2001, Through January 31, 2011
Initial Investment of $25,000

Spliced Energy Index: S&P 500 Index through November 30, 2000; S&P Energy Sector Index through May 31, 2010; MSCI All Country World Energy Index thereafter.
Global Natural Resources Funds Average: Derived from data provided by Lipper Inc.

Vanguard fund returns do not reflect the 1% fee on redemptions of shares held for less than one year.
See Financial Highlights for dividend and capital gains information.

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Energy Fund

 

Fiscal-Year Total Returns (%): January 31, 2001, Through January 31, 2011

Average Annual Total Returns: Periods Ended December 31, 2010
This table presents average annual total returns through the latest calendar quarter—rather than through the end of the fiscal period. Securities and Exchange Commission rules require that we provide this information.

 

Vanguard fund returns do not reflect the 1% fee on redemptions of shares held for less than one year.

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Energy Fund

Financial Statements

Statement of Net Assets
As of January 31, 2011

The fund reports a complete list of its holdings in regulatory filings four times in each fiscal year, at the quarter-ends. For the second and fourth fiscal quarters, the lists appear in the fund’s semiannual and annual reports to shareholders. For the first and third fiscal quarters, the fund files the lists with the Securities and Exchange Commission on Form N-Q. Shareholders can look up the fund’s Forms N-Q on the SEC’s website at sec.gov. Forms N-Q may also be reviewed and copied at the SEC’s Public Reference Room (see the back cover of this report for further information).

 

 

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Energy Fund

 

 

15

 

Energy Fund

 

 

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Energy Fund

 

See Note A in Notes to Financial Statements.
* Non-income-producing security.
^ Part of security position is on loan to broker-dealers. The total value of securities on loan is $13,643,000.
1 The fund invests a portion of its cash reserves in equity markets through the use of index futures contracts. After giving effect to futures Investments, the fund’s effective common stock and temporary cash investment positions represent 97.0% and 2.9%, respectively, of net assets.
2 Considered an affiliated company of the fund as the issuer is another member of The Vanguard Group.
3 Considered an affiliated company of the fund as the fund owns more than 5% of the outstanding voting securities of such company.
4 Affiliated money market fund available only to Vanguard funds and certain trusts and accounts managed by Vanguard. Rate shown is the 7-day yield.
5 Includes $13,958,000 of collateral received for securities on loan.
6 The issuer operates under a congressional charter; its securities are not backed by the full faith and credit of the U.S. government.
7 Securities with a value of $20,285,000 have been segregated as initial margin for open futures contracts.
ADR—American Depositary Receipt.
GDR—Global Depositary Receipt.
See accompanying Notes, which are an integral part of the Financial Statements.

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Energy Fund

Statement of Operations

1 Dividends are net of foreign withholding taxes of $14,628,000.
2 Dividend income, interest income, and realized net gain (loss) from affiliated companies of the fund were $1,769,000, $298,000, and ($1,581,000), respectively.

See accompanying Notes, which are an integral part of the Financial Statements.

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Energy Fund

Statement of Changes in Net Assets

1 Includes fiscal 2011 short-term gain distributions totaling $62,911,000. Short-term gain distributions are treated as ordinary income dividends for tax purposes.
2 Net Assets—End of Period includes undistributed (overdistributed) net investment income of ($16,406,000) and ($18,896,000).

See accompanying Notes, which are an integral part of the Financial Statements.

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Energy Fund

Financial Highlights

Investor Shares

1 Calculated based on average shares outstanding.
2 Total returns do not include transaction or account service fees that may have applied in the periods shown. Fund prospectuses provide information about any applicable transaction and account service fees.
3 Includes performance-based investment advisory fee increases (decreases) of 0.00% for fiscal 2011, 0.03% for fiscal 2010, and 0.01% for fiscal 2009.

See accompanying Notes, which are an integral part of the Financial Statements.

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Energy Fund

Financial Highlights

Admiral Shares

1 Calculated based on average shares outstanding.
2 Total returns do not include transaction fees that may have applied in the periods shown. Fund prospectuses provide information about any applicable transaction fees.
3 Includes performance-based investment advisory fee increases (decreases) of 0.00% for fiscal 2011, 0.03% for fiscal 2010, and 0.01% for fiscal 2009.

See accompanying Notes, which are an integral part of the Financial Statements.

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Energy Fund

Notes to Financial Statements

Vanguard Energy Fund is registered under the Investment Company Act of 1940 as an open-end investment company, or mutual fund. The fund invests in securities of foreign issuers, which may subject it to investment risks not normally associated with investing in securities of U.S. corporations. The fund offers two classes of shares: Investor Shares and Admiral Shares. Investor Shares are available to any investor who meets the fund’s minimum purchase requirements. Admiral Shares are designed for investors who meet certain administrative, service, and account-size criteria.

A. The following significant accounting policies conform to generally accepted accounting principles for U.S. mutual funds. The fund consistently follows such policies in preparing its financial statements.

1. Security Valuation: Securities are valued as of the close of trading on the New York Stock Exchange (generally 4 p.m., Eastern time) on the valuation date. Equity securities are valued at the latest quoted sales prices or official closing prices taken from the primary market in which each security trades; such securities not traded on the valuation date are valued at the mean of the latest quoted bid and asked prices. Securities for which market quotations are not readily available, or whose values have been affected by events occurring before the fund’s pricing time but after the close of the securities’ primary markets, are valued at their fair values calculated according to procedures adopted by the board of trustees. These procedures include obtaining quotations from an independent pricing service, monitoring news to identify significant market- or security-specific events, and evaluating changes in the values of foreign market proxies (for example, ADRs, futures contracts, or exchange-traded funds), between the time the foreign markets close and the fund’s pricing time. When fair-value pricing is employed, the prices of securities used by a fund to calculate its net asset value may differ from quoted or published prices for the same securities. Investments in Vanguard Market Liquidity Fund are valued at that fund’s net asset value. Temporary cash investments acquired over 60 days to maturity are valued using the latest bid prices or using valuations based on a matrix system (which considers such factors as security prices, yields, maturities, and ratings), both as furnished by independent pricing services. Other temporary cash investments are valued at amortized cost, which approximates market value.

2. Foreign Currency: Securities and other assets and liabilities denominated in foreign currencies are translated into U.S. dollars using exchange rates obtained from an independent third party as of the fund’s pricing time on the valuation date. Realized gains (losses) and unrealized appreciation (depreciation) on investment securities include the effects of changes in exchange rates since the securities were purchased, combined with the effects of changes in security prices. Fluctuations in the value of other assets and liabilities resulting from changes in exchange rates are recorded as unrealized foreign currency gains (losses) until the assets or liabilities are settled in cash, at which time they are recorded as realized foreign currency gains (losses).

3. Futures Contracts: The fund uses index futures contracts to a limited extent, with the objective of maintaining full exposure to the stock market while maintaining liquidity. The fund may purchase or sell futures contracts to achieve a desired level of investment, whether to accommodate portfolio turnover or cash flows from capital share transactions. The primary risks associated with the use of futures contracts are imperfect correlation between changes in market values of stocks held by the fund and the prices of futures contracts, and the possibility of an illiquid market.

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Energy Fund

Futures contracts are valued at their quoted daily settlement prices. The aggregate principal amounts of the contracts are not recorded in the Statement of Net Assets. Fluctuations in the value of the contracts are recorded in the Statement of Net Assets as an asset (liability) and in the Statement of Operations as unrealized appreciation (depreciation) until the contracts are closed, when they are recorded as realized futures gains (losses).

4. Repurchase Agreements: The fund invests in repurchase agreements. Securities pledged as collateral for repurchase agreements are held by a custodian bank until the agreements mature. Each agreement requires that the market value of the collateral be sufficient to cover payments of interest and principal; however, in the event of default or bankruptcy by the other party to the agreement, retention of the collateral may be subject to legal proceedings.

5. Federal Income Taxes: The fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. Management has analyzed the fund’s tax positions taken for all open federal income tax years (January 31, 2008–2011), and has concluded that no provision for federal income tax is required in the fund’s financial statements.

6. Distributions: Distributions to shareholders are recorded on the ex-dividend date.

7. Security Lending: The fund may lend its securities to qualified institutional borrowers to earn additional income. Security loans are required to be secured at all times by collateral at least equal to the market value of securities loaned. The fund invests cash collateral received in Vanguard Market Liquidity Fund, and records a liability for the return of the collateral, during the period the securities are on loan. Security lending income represents fees charged to borrowers plus income earned on investing cash collateral, less expenses associated with the loan.

8. Other: Dividend income is recorded on the ex-dividend date. Interest income includes income distributions received from Vanguard Market Liquidity Fund and is accrued daily. Security transactions are accounted for on the date securities are bought or sold. Costs used to determine realized gains (losses) on the sale of investment securities are those of the specific securities sold. Fees assessed on redemptions of capital shares are credited to paid-in capital.

Each class of shares has equal rights as to assets and earnings, except that each class separately bears certain class-specific expenses related to maintenance of shareholder accounts (included in Management and Administrative expenses) and shareholder reporting. Marketing and distribution expenses are allocated to each class of shares based on a method approved by the board of trustees. Income, other non-class-specific expenses, and gains and losses on investments are allocated to each class of shares based on its relative net assets.

B. Wellington Management Company, LLP, provides investment advisory services to a portion of the fund for a fee calculated at an annual percentage rate of average net assets managed by the advisor. The basic fee is subject to quarterly adjustments based on the fund’s performance for the preceding three years relative to a combined index composed of the S&P Citigroup BMI World Energy Index and the S&P 500 Energy Equal Weighted Blend Index through July 31, 2010, and the MSCI ACWI Energy Index thereafter. The benchmark change will be fully phased in by July 31, 2013.

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Energy Fund

The Vanguard Group provides investment advisory services to a portion of the fund on an at-cost basis; the fund paid Vanguard advisory fees of $349,000 for the year ended January 31, 2011.

For the year ended January 31, 2011, the aggregate investment advisory fee represented an effective annual basic rate of 0.14% of the fund’s average net assets, before an increase of $180,000 (0.00%) based on performance.

C. The Vanguard Group furnishes at cost corporate management, administrative, marketing, and distribution services. The costs of such services are allocated to the fund under methods approved by the board of trustees. The fund has committed to provide up to 0.40% of its net assets in capital contributions to Vanguard. At January 31, 2011, the fund had contributed capital of $2,134,000 to Vanguard (included in Other Assets), representing 0.02% of the fund’s net assets and 0.85% of Vanguard’s capitalization. The fund’s trustees and officers are also directors and officers of Vanguard.

D. The fund has asked its investment advisors to direct certain security trades, subject to obtaining the best price and execution, to brokers who have agreed to rebate to the fund part of the commissions generated. Such rebates are used solely to reduce the fund’s management and administrative expenses. For the year ended January 31, 2011, these arrangements reduced the fund’s expenses by $119,000 (an annual rate of 0.00% of average net assets).

E. Various inputs may be used to determine the value of the fund’s investments. These inputs are summarized in three broad levels for financial statement purposes. The inputs or methodologies used to value securities are not necessarily an indication of the risk associated with investing in those securities.

Level 1—Quoted prices in active markets for identical securities.
Level 2—Other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.).
Level 3—Significant unobservable inputs (including the fund’s own assumptions used to determine the fair value of investments).

The following table summarizes the fund’s investments as of January 31, 2011, based on the inputs used to value them:

 

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Energy Fund

F. At January 31, 2011, the aggregate settlement value of open futures contracts and the related unrealized appreciation (depreciation) were:

 

Unrealized appreciation (depreciation) on open futures contracts is required to be treated as realized gain (loss) for tax purposes.

G. Distributions are determined on a tax basis and may differ from net investment income and realized capital gains for financial reporting purposes. Differences may be permanent or temporary. Permanent differences are reclassified among capital accounts in the financial statements to reflect their tax character. Temporary differences arise when certain items of income, expense, gain, or loss are recognized in different periods for financial statement and tax purposes; these differences will reverse at some time in the future. Differences in classification may also result from the treatment of short-term gains as ordinary income for tax purposes.

During the year ended January 31, 2011, the fund realized net foreign currency losses of $320,000, which decreased distributable net income for tax purposes; accordingly, such losses have been reclassified from accumulated net realized gains to overdistributed net investment income.

The fund’s realized gains for the year ended January 31, 2011, include $52,000 of capital gain tax paid on sales of Indian securities. This tax is treated as a decrease in taxable income; accordingly, this amount has been reclassified from accumulated net realized gains to overdistributed net investment income.

The fund used a tax accounting practice to treat a portion of the price of capital shares redeemed during the year as distributions from net investment income and realized capital gains. Accordingly, the fund has reclassified $11,798,000 from overdistributed net investment income, and $26,531,000 from accumulated net realized gains, to paid-in capital.

For tax purposes, at January 31, 2011, the fund had $26,005,000 of ordinary income and $77,255,000 of long-term capital gains available for distribution.

At January 31, 2011, the cost of investment securities for tax purposes was $8,103,474,000. Net unrealized appreciation of investment securities for tax purposes was $5,480,801,000, consisting of unrealized gains of $5,588,942,000 on securities that had risen in value since their purchase and $108,141,000 in unrealized losses on securities that had fallen in value since their purchase.

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Energy Fund

H. During the year ended January 31, 2011, the fund purchased $3,341,218,000 of investment securities and sold $3,435,279,000 of investment securities, other than temporary cash investments.

I. Capital share transactions for each class of shares were:

 

J. The fund has invested in a company that is considered to be an affiliated company of the fund because the fund owns more than 5% of the outstanding voting securities of the company. Transactions during the period in securities of this company were as follows:

 

K. In preparing the financial statements as of January 31, 2011, management considered the impact of subsequent events for potential recognition or disclosure in these financial statements.

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Report of Independent Registered
Public Accounting Firm

To the Trustees of Vanguard Specialized Funds and the Shareholders of Vanguard Energy Fund:

In our opinion, the accompanying statement of net assets and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Vanguard Energy Fund (constituting a separate portfolio of Vanguard Specialized Funds, hereafter referred to as the “Fund”) at January 31, 2011, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended and the financial highlights for each of the five years in the period then ended, in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as “financial statements”) are the responsibility of the Fund’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at January 31, 2011 by correspondence with the custodians and brokers and by agreement to the underlying ownership records of Vanguard Market Liquidity Fund, provide a reasonable basis for our opinion.

PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania

March 11, 2011

 

 

This information for the fiscal year ended January 31, 2011, is included pursuant to provisions of the Internal Revenue Code.

The fund distributed $362,151,000 as capital gain dividends (from net long-term capital gains) to shareholders during the fiscal year.

The fund distributed $148,606,000 of qualified dividend income to shareholders during the fiscal year.

For corporate shareholders, 42.2% of investment income (dividend income plus short-term gains, if any) qualifies for the dividends-received deduction.

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Your Fund’s After-Tax Returns

This table presents returns for your fund both before and after taxes. The after-tax returns are shown in two ways: (1) assuming that an investor owned the fund during the entire period and paid taxes on the fund’s distributions, and (2) assuming that an investor paid taxes on the fund’s distributions and sold all shares at the end of each period.

Calculations are based on the highest individual federal income tax and capital gains tax rates in effect at the times of the distributions and the hypothetical sales. State and local taxes were not considered. After-tax returns reflect any qualified dividend income , using actual prior-year figures and estimates for 2011. (In the example, returns after the sale of fund shares may be higher than those assuming no sale. This occurs when the sale would have produced a capital loss. The calculation assumes that the investor received a tax deduction for the loss.) The table shows returns for Investor Shares only; returns for other share classes will differ. Please note that your actual after-tax returns will depend on your tax situation and may differ from those shown. Also note that if you own the fund in a tax-deferred account, such as an individual retirement account or a 401(k) plan, this information does not apply to you. Such accounts are not subject to current taxes.

Finally, keep in mind that a fund’s performance—whether before or after taxes—does not guarantee future results.

Average Annual Total Returns: Energy Fund Investor Shares
Periods Ended January 31, 2011

 

Returns do not reflect the 1% fee on redemptions of shares held for less than one year.

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About Your Fund’s Expenses

As a shareholder of the fund, you incur ongoing costs, which include costs for portfolio management, administrative services, and shareholder reports (like this one), among others. Operating expenses, which are deducted from a fund’s gross income, directly reduce the investment return of the fund.

A fund’s expenses are expressed as a percentage of its average net assets. This figure is known as the expense ratio. The following examples are intended to help you understand the ongoing costs (in dollars) of investing in your fund and to compare these costs with those of other mutual funds. The examples are based on an investment of $1,000 made at the beginning of the period shown and held for the entire period.

The accompanying table illustrates your fund’s costs in two ways:

• Based on actual fund return. This section helps you to estimate the actual expenses that you paid over the period. The ”Ending Account Value“ shown is derived from the fund‘s actual return, and the third column shows the dollar amount that would have been paid by an investor who started with $1,000 in the fund. You may use the information here, together with the amount you invested, to estimate the expenses that you paid over the period.

To do so, simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number given for your fund under the heading ”Expenses Paid During Period.“

• Based on hypothetical 5% yearly return. This section is intended to help you compare your fund‘s costs with those of other mutual funds. It assumes that the fund had a yearly return of 5% before expenses, but that the expense ratio is unchanged. In this case—because the return used is not the fund’s actual return—the results do not apply to your investment. The example is useful in making comparisons because the Securities and Exchange Commission requires all mutual funds to calculate expenses based on a 5% return. You can assess your fund’s costs by comparing this hypothetical example with the hypothetical examples that appear in shareholder reports of other funds.

Note that the expenses shown in the table are meant to highlight and help you compare ongoing costs only and do not reflect transaction costs incurred by the fund for buying and selling securities. Further, the expenses do not include the 1% fee on redemptions of shares held for less than one year, nor do they include the account service fee described in the prospectus. If such fees were applied to your account, your costs would be higher. Your fund does not carry a “sales load.” The calculations assume no shares were bought or sold during the period. Your actual costs may have been higher or lower, depending on the amount of your investment and the timing of any purchases or redemptions.

You can find more information about the fund’s expenses, including annual expense ratios, in the Financial Statements section of this report. For additional information on operating expenses and other shareholder costs, please refer to your fund’s current prospectus.

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Six Months Ended January 31, 2011

The calculations are based on expenses incurred in the most recent six-month period. The fund’s annualized six-month expense ratios for that period are 0.33% for Investor Shares and 0.27% for Admiral Shares. The dollar amounts shown as “Expenses Paid” are equal to the annualized expense ratio multiplied by the average account value over the period, multiplied by the number of days in the most recent six-month period, then divided by the number of days in the most recent 12-month period.

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Glossary

30-Day SEC Yield. A fund’s 30-day SEC yield is derived using a formula specified by the U.S. Securities and Exchange Commission. Under the formula, data related to the fund’s security holdings in the previous 30 days are used to calculate the fund’s hypothetical net income for that period, which is then annualized and divided by the fund’s estimated average net assets over the calculation period. For the purposes of this calculation, a security’s income is based on its current market yield to maturity (in the case of bonds) or its projected dividend yield (for stocks). Because the SEC yield represents hypothetical annualized income, it will differ—at times significantly—from the fund’s actual experience. As a result, the fund’s income distributions may be higher or lower than implied by the SEC yield.

Beta. A measure of the magnitude of a fund’s past share-price fluctuations in relation to the ups and downs of a given market index. The index is assigned a beta of 1.00. Compared with a given index, a fund with a beta of 1.20 typically would have seen its share price rise or fall by 12% when the index rose or fell by 10%. For this report, beta is based on returns over the past 36 months for both the fund and the index. Note that a fund’s beta should be reviewed in conjunction with its R-squared (see definition). The lower the R-squared, the less correlation there is between the fund and the index, and the less reliable beta is as an indicator of volatility.

Dividend Yield. Dividend income earned by stocks, expressed as a percentage of the aggregate market value (or of net asset value, for a fund). The yield is determined by dividing the amount of the annual dividends by the aggregate value (or net asset value) at the end of the period. For a fund, the dividend yield is based solely on stock holdings and does not include any income produced by other investments.

Earnings Growth Rate. The average annual rate of growth in earnings over the past five years for the stocks now in a fund.

Equity Exposure. A measure that reflects a fund’s investments in stocks and stock futures. Any holdings in short-term reserves are excluded.

Expense Ratio. The percentage of a fund’s average net assets used to pay its annual administrative and advisory expenses. These expenses directly reduce returns to investors.

Foreign Holdings. The percentage of a fund represented by stocks or depositary receipts of companies based outside the United States.

Inception Date. The date on which the assets of a fund (or one of its share classes) are first invested in accordance with the fund’s investment objective. For funds with a subscription period, the inception date is the day after that period ends. Investment performance is measured from the inception date.

Median Market Cap. An indicator of the size of companies in which a fund invests; the midpoint of market capitalization (market price x shares outstanding) of a fund’s stocks, weighted by the proportion of the fund’s assets invested in each stock. Stocks representing half of the fund’s assets have market capitalizations above the median, and the rest are below it.

Price/Book Ratio. The share price of a stock divided by its net worth, or book value, per share. For a fund, the weighted average price/book ratio of the stocks it holds.

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Price/Earnings Ratio. The ratio of a stock’s current price to its per-share earnings over the past year. For a fund, the weighted average P/E of the stocks it holds. P/E is an indicator of market expectations about corporate prospects; the higher the P/E, the greater the expectations for a company’s future growth.

R-Squared. A measure of how much of a fund’s past returns can be explained by the returns from the market in general, as measured by a given index. If a fund’s total returns were precisely synchronized with an index’s returns, its R-squared would be 1.00. If the fund’s returns bore no relationship to the index’s returns, its R-squared would be 0. For this report, R-squared is based on returns over the past 36 months for both the fund and the index.

Return on Equity. The annual average rate of return generated by a company during the past five years for each dollar of shareholder’s equity (net income divided by shareholder’s equity). For a fund, the weighted average return on equity for the companies whose stocks it holds.

Short-Term Reserves. The percentage of a fund invested in highly liquid, short-term securities that can be readily converted to cash.

Turnover Rate. An indication of the fund’s trading activity. Funds with high turnover rates incur higher transaction costs and may be more likely to distribute capital gains (which may be taxable to investors). The turnover rate excludes in-kind transactions, which have minimal impact on costs.

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The People Who Govern Your Fund

The trustees of your mutual fund are there to see that the fund is operated and managed in your best interests since, as a shareholder, you are a part owner of the fund. Your fund’s trustees also serve on the board of directors of The Vanguard Group, Inc., which is owned by the Vanguard funds and provides services to them on an at-cost basis.

A majority of Vanguard’s board members are independent, meaning that they have no affiliation with Vanguard or the funds they oversee, apart from the sizable personal investments they have made as private individuals. The independent board members have distinguished backgrounds in business, academia, and public service. Each of the trustees and executive officers oversees 179 Vanguard funds.

The following table provides information for each trustee and executive officer of the fund. More information about the trustees is in the Statement of Additional Information, which can be obtained, without charge, by contacting Vanguard at 800-662-7447, or online at vanguard.com.

 

 

 

1 Mr. McNabb is considered an “interested person,” as defined in the Investment Company Act of 1940, because he is an officer of the Vanguard funds.
2 December 2002 for Vanguard Equity Income Fund, Vanguard Growth Equity Fund, the Vanguard Municipal Bond Funds, and the Vanguard State Tax-Exempt Funds.

 

 

 

Connect with Vanguard® > vanguard.com

 

 

 

 

 

> For the fiscal year ended January 31, 2011, Vanguard Precious Metals and Mining Fund returned about 35%.

> The fund’s return lagged that of its benchmark for the period, as well as the average return of its peer-group funds. Poor selection in nongold stocks held back results.

> Gold stocks were the most significant contributors to returns, while platinum companies were the biggest drags on performance.

 

Please note: The opinions expressed in this report are just that—informed opinions. They should not be considered promises or advice.
Also, please keep in mind that the information and opinions cover the period through the date on the front of this report. Of course, the risks of investing in your fund are spelled out in the prospectus.
See the Glossary for definitions of investment terms used in this report.

Cover photograph: Jean Maher.

 

Your Fund’s Total Returns

Fiscal Year Ended January 31, 2011

 

Your Fund’s Performance at a Glance
January 31, 2010 , Through January 31, 2011

 

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Chairman’s Letter

Dear Shareholder,

After a long and bumpy ride, U.S. and international stocks posted robust returns for the fiscal year ended January 31, 2011. Most commodities prices, including silver, gold, and platinum, notched significant double-digit gains for the period, helping the precious metals and mining industry outperform the broad stock market.

Vanguard Precious Metals and Mining Fund returned 35.35% for the period. Despite that impressive return, the fund lagged both its target index (+43.00%) and its peer-group average (+41.56%). The fund’s sizable exposure to platinum mining companies, along with a limited exposure to gold stocks, played a role in this lag in performance.

If you hold the fund in a taxable account, you may wish to review information on after-tax performance provided later in this report.

Stocks rallied as economy ground into gear
Global stock markets produced excellent returns in the year ended January 31, 2011, with much of the strength materializing in the second half of the year. Europe’s sovereign debt challenges and concerns that the economic recovery in the United States might not reach escape velocity

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seemed to recede from investors’ minds, displaced by strong corporate earnings and a powerful rebound in consumer spending and in the manufacturing sector.

The U.S. stock market returned about 24%. Small- and mid-capitalization stocks, often the first to respond to changes in the economic outlook, did even better. As a group, non-U.S. stock markets returned more than 18%. Emerging markets were the best performers. Despite high-profile dramas in Europe’s government bond markets, European stocks produced double-digit gains. Asia’s developed markets turned in mixed results on local exchanges, but the strength of the yen, the Australian dollar, and other regional currencies bolstered returns for U.S.-based investors.

A strong start, a faltering finish for bonds
In January 2010, the bond market’s near-term prospects looked dubious, in large part because yields hovered near generational lows. Over the following 12 months, however, yields dipped lower still. The taxable bond market returned about 5% for the year. As investors searched for yield, corporate bonds produced the best returns, with the riskiest credits leading the market.

Toward the end of the fiscal year, an improving economic outlook nudged interest rates higher, putting pressure on bond prices. This dynamic was evident in the municipal bond market, where rising rates and a confluence of other factors weighed on prices. The expiration of the

Market Barometer

 

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Build America Bonds program, for example, raised the prospect of a spike in new tax-exempt issuance, while the extension of federal tax rate cuts that were set to expire made munis’ tax exemption somewhat less attractive. For the full year, the muni market returned about 1%.

As it has since December 2008, the Federal Reserve held its target for short-term interest rates near 0%, keeping the returns available from money market instruments such as the 3-month Treasury bill in the same neighborhood.

Heavy exposure to platinum muted fund performance
Vanguard Precious Metals and Mining Fund focuses on a small sector of the global stock market: companies that are involved in the mining of or exploration for precious and rare metals and minerals. Although the fund holds only about 40–50 stocks, they are diversified among the subsectors of the broad metals and mining industry. While diversification can help moderate some of the swings common in this notoriously volatile sector, investors should still expect the fund’s returns to vary widely from year to year.

Prices for silver (+73%), gold (+23%), and platinum (+19%) rose notably in the year ended January 31. In this investment environment, Vanguard Precious Metals and Mining Fund’s return—while impressive—lagged those of its comparative standards, which typically have more exposure to gold-oriented stocks and less to stocks related to other metals.

Expense Ratios
Your Fund Compared With Its Peer Group

The fund expense ratio shown is from the prospectus dated May 28, 2010, and represents estimated costs for the current fiscal year. For the fiscal year ended January 31, 2011, the fund’s expense ratio was 0.27%. The peer-group expense ratio is derived from data provided by Lipper Inc. and captures information through year-end 2010.

Peer group: Precious Metal Funds.

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Although gold prices didn’t spike as high (in percentage terms) as those of some other metals during the period, gold set a new record and the majority of gold stocks performed exceptionally well. Gold is often considered a form of “insurance” against financial turmoil and global unrest, and events such as Europe’s sovereign debt crisis and extraordinary monetary initiatives in the United States added to its luster in the past year.

The fund’s relatively light exposure to gold-mining companies notwithstanding, such stocks were by far the most significant contributor to performance. Gold-oriented companies, including Centerra Gold (+59%) and Nevsun Resources (+211%), added more than 16 percentage points to the fund’s overall returns.

In an environment where some gold stocks produce triple-digit returns, clearly, more exposure is better; so the fund paid a price for its heavy allocation to other metals and minerals stocks. Platinum stocks, in particular, hurt results. Even though prices for the scarce metal rose almost as much as gold prices, in percentage terms, platinum mining companies—including Lonmin and Anglo Platinum, two of the world’s largest producers—suffered as strikes and other issues in their South African mines disrupted production.

In recent years, the fund has maintained heavy exposure to platinum stocks relative to the benchmark. However, during the period, the fund’s advisor, M&G Investment Management Ltd., began to slowly decrease the portfolio’s exposure to the

Total Returns
Ten Years Ended January 31, 2011

Spliced Precious Metals and Mining Index: S&P/Citigroup World Equity Gold Index through June 30, 2005; S&P Custom Precious Metals and Mining Index thereafter.

Precious Metal Funds Average: Derived from data provided by Lipper Inc.

The figures shown represent past performance, which is not a guarantee of future results. (Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance.) Note, too, that both investment returns and principal value can fluctuate widely, so an investor’s shares, when sold, could be worth more or less than their original cost.

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metal, bringing it more in line with the benchmark’s weighting, while at the same time increasing the portfolio’s allocation to gold stocks.

Fund returns benefited from strong stock selection in diversified metals and mining. Together, mineral sands miner Iluka Resources, Australian copper miner OZ Minerals, and diversified natural resource producer Sherritt International added more than 9 percentage points to the fund’s return.

Long-term performance remains impressive despite recent volatility
For the ten-year period ended January 31, the fund posted an average annual return of 21.39%. The fund’s returns were in line with those of its benchmark (+21.37%), and slightly less than the peer-group average (+23.16%). The fund significantly outperformed the broad U.S. stock market, which produced an average return of 2.47% a year over the past decade. These striking returns should be treated with extreme caution: In this highly volatile segment of the market, performance can turn quickly. For fiscal 2009, for example, the fund returned –60.16%, a result that was more than 20 percentage points worse than the –38.69% return of the overall U.S. stock market for the same period.

The fund’s advisor, London-based M&G Investment Management, has ably steered the fund through the inevitable ups and downs associated with this market segment. The advisor uses a bottom-up stock selection process that focuses on well-managed and returns-focused companies across the universe of precious metals and mining stocks. Thanks to its investment mandate, the fund is allowed to be more diversified than most of its peers; this helps temper some of the volatility that comes with this sector. And the fund’s exceptionally low expenses help investors keep more of the fund’s return.

A broadly diversified portfolio is always a good option
In recent years, investors have been involuntary passengers on the market’s wild ride. And while returns have been much brighter lately, we still can’t know what the future holds. However, one thing that we do know is that trying to predict when the market will rise or fall is a losing game.

The best way to deal with the market’s unpredictability is to create a long-term investment plan—one that includes a mix of stocks, bonds, and short-term investments that is appropriate for your goals and risk tolerance—and then stick with that plan, regardless of market conditions.

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Vanguard Precious Metals and Mining Fund can play a minor role in such a well-balanced portfolio, providing exposure to precious metals and mining stocks in regions around the world. The fund’s highly concentrated focus on a narrow segment of the market can mean big risks and volatility, but the potential ups and downs loom much less large when the fund is used as a small component in a well-diversified portfolio.

As always, thank you for entrusting your assets to Vanguard.

Sincerely,

F. William McNabb III
Chairman and Chief Executive Officer
February 9, 2011

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Advisor’s Report

Vanguard Precious Metals and Mining Fund produced a strong absolute return of 35.35% for the 12 months ended January 31, 2011. However, this result lagged that of the fund’s customized benchmark index, which gained 43.00%, and the 41.56% average return of its precious metals fund peers.

The markets
The price of gold continued its long-term strength during the period under review. The price per ounce rose from $1,100 at the start of February 2010, breaking $1,400 for the first time ever in November 2010 before finishing the period at $1,337 per ounce. A number of factors contributed to this performance. Initially, as concerns mounted regarding the impact of the sovereign debt crisis in Europe, investors were drawn to the metal’s “safehaven” qualities. As these fears gave way to greater optimism about the health of the global economy, gold prices were buoyed by investors’ perception that the metal would act as a hedge against rising inflation. Increased gold investment activity from China and a rebound in jewelry consumption in India, the world’s largest jewelry market, also played a role. Rising costs of extraction and declining ore grades around the world added support from the supply side.

Outside of gold, healthy global economic growth, supply-side constraints, and robust demand—especially from emerging markets—for natural resources resulted in a strong period for metals and minerals with broader industrial uses, as well as for the companies that produce them. Silver, copper, and iron ore all approached or reached record highs during the period, while platinum and nickel also registered strong gains.

The fund’s performance
In terms of contributors to fund performance, our preference for mid- capitalization gold producers with significant exploration potential, rather than the large North American producers (where valuations are, in our view, less attractive), proved beneficial. Canadian- listed producers Centerra Gold (which owns high-quality gold assets in Central Asia and the former Soviet Union) and Nevsun Resources (attractively valued gold assets in Eritrea), and U.K.-listed Hochschild Mining (silver and gold assets across Latin America) were among the holdings that added the most value.

The fund’s gold weighting remains focused on value-creating businesses that are improving their operating efficiency and long-term profitability. Some, such as Centerra, have recently initiated a dividend, an encouraging development that reflects improving attitudes toward capital allocation in the gold industry.

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Elsewhere, well-managed, high-quality Australian mineral sands producer Iluka Resources was a noteworthy positive contributor, boosted by extremely robust demand for zircon, which is used in a broad range of industrial and consumer-oriented applications. Long-term prices for the mineral should be supported by the paucity of new sources of supply.

Turning to detractors, one of the central factors in the fund’s underperformance relative to the benchmark was its exposure to platinum. The fund’s holdings in U.K.-listed platinum producer Lonmin and South African producer Impala Platinum were hurt by a number of political and operational challenges, the most prominent being rising production costs at Lonmin as a result of ongoing problems with one of its key furnaces. A number of the fund’s other holdings, including Australian metal recycler Sims Metal Management, French kaolin producer Imerys, and Singapore-listed commodities logistics business Noble Group, failed to keep up with the broader mining rally.

Purchases and sales
We reduced the fund’s significant exposure to South African-based producers of platinum by selling out of Anglo Platinum and Impala Platinum. We did this partly in light of increased uncertainty regarding the political and operational environment in South Africa. Elsewhere, we decided to take profits from some of those stocks that have performed particularly well for the portfolio, but where the investment rationale was no longer as compelling as it had been. With this in mind, we closed the fund’s positions in U.K.-listed platinum processor Johnson Matthey, U.S. specialty minerals producer Minerals Technologies, and U.S. coal producer Peabody Energy.

By contrast, we made significant investments in gold producers during the past year, with a focus on firms that are generating high returns and cash flows from producing assets and that also have developmental possibilities. To that end, we initiated and built up substantial positions in Canada-listed gold miners Semafo and Anatolia Minerals Development and added to existing holdings in the aforementioned Centerra Gold and Nevsun Resources.

We also added to our holdings in Australian iron ore producer Aquila Resources, a well-managed business with valuable iron ore assets that are well positioned to supply growing Asian demand, and German potash producer K+S, a strong beneficiary of rising global demand for fertilizer products that improve crop yields. Finally, we built up a large position in returns-focused Australian copper and gold producer OZ Minerals, a highly cash-generative business with a capable management team and significant—and underappreciated—development potential.

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Looking ahead
We continue to believe that appetite for a broad range of commodities will be supported over many years by infrastructure expenditure worldwide, as well as by industrialization and rising urbanization in developing markets. We remain convinced of the merits of sticking to long-term principles and focusing on both structural supply/demand imbalances and company fundamentals. In light of ongoing uncertainty about the global economic outlook, we shall continue to invest in financially sound, well-managed companies with strategically important assets whose value, we believe, is not properly appreciated by investors. It is of great importance to us that a company’s long-term growth prospects are supported by its recognition of the value of a returns- focused approach.

Portfolio Managers:

Graham E. French

Matthew Vaight, UKSIP

M&G Investment Management Ltd.

February 23, 2011

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Precious Metals and Mining Fund

Fund Profile
As of January 31, 2011

 

 

Allocation by Region (% of equity exposure)

1 The expense ratio shown is from the prospectus dated May 28, 2010, and represents estimated costs for the current fiscal year. For the fiscal year ended January 31, 2011, the expense ratio was 0.27%.

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