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

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT
OF
REGISTERED MANAGEMENT INVESTMENT COMPANIES

 

 

 

Semiannual Report | July 31, 2016

Vanguard Energy Fund

 

Vanguard’s Principles for Investing Success

We want to give you the best chance of investment success. These principles, grounded in Vanguard’s research and experience, can put you on the right path.

Goals. Create clear, appropriate investment goals.

Balance. Develop a suitable asset allocation using broadly diversified funds. Cost. Minimize cost.

Discipline. Maintain perspective and long-term discipline.

A single theme unites these principles: Focus on the things you can control.

We believe there is no wiser course for any investor.

 

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.
About the cover: Pictured is a sailing block on the Brilliant, a 1932 schooner docked in Mystic, Connecticut. A type of pulley, the
sailing block helps coordinate the setting of the sails. At Vanguard, the intricate coordination of technology and people allows
us to help millions of clients around the world reach their financial goals.

 

Your Fund’s Total Returns

 

 

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Chairman’s Letter

Dear Shareholder,

For the six months ended July 31, 2016, energy stocks posted a strong double-digit gain, a reversal from the past two fiscal years of double-digit declines. The sector went from being the broad U.S. stock market’s worst performer for five consecutive fiscal years to being one of the best for the half year.

With oil prices largely on the upswing during the period, Vanguard Energy Fund returned almost 22%, outpacing its benchmark index and the average return of global natural resource funds. (Many peers have significant allocations to sectors other than energy, such as materials.)

By late July, however, the fragile balance of supply and demand had shifted once more, and oil prices slid again. Such movements are a reminder that, as I have cautioned in previous reports, a narrowly focused sector fund is better suited to play a complementary—rather than a core—role in a portfolio that is already balanced and diversified across and within asset classes.

U.S. stocks continued to surge despite signs of uncertainty

U.S. stocks proved resilient over the half year, returning about 14%, although the global environment was far from tranquil.

Stocks tumbled after the momentous June 23 decision by U.K. voters to leave the European Union. But the market

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quickly recovered. Worries about the effects of “Brexit” on trade and economic growth seemed to diminish as expectations rose that major central banks would be responsive to any fallout.

International stocks also performed well, returning nearly 12%. European stocks finished solidly but still lagged as the Brexit referendum hit close to home. Emerging-market stocks and those from developed Pacific markets recorded double-digit returns.

Bonds drew support given economic factors and low yields

The broad U.S. taxable bond market advanced in each of the six months en route to returning 4.54%. With the stock market volatile at times and the global growth pace uncertain, investors sought safe-haven assets. Foreign investors flocked to U.S. Treasury debt amid exceptionally low or negative yields abroad.

The yield of the 10-year Treasury note closed July at 1.45%, down from 1.98% at the end of January. (Bond prices and yields move in opposite directions.)

The Federal Reserve has held its target for short-term interest rates at 0.25%–0.5% since raising it by a quarter percentage point last December. Money market funds and savings accounts stayed restrained by these historically low rates.

International bond markets (as measured by the Barclays Global Aggregate Index ex USD) returned more than 12% for U.S.

 

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investors. A number of foreign currencies strengthened against the dollar, lifting returns when translated into U.S. dollars, but the bond returns were robust even without this currency benefit.

Most energy segments advanced, aside from refiners and marketers

Since oil prices began their steep descent in the summer of 2014, hardly a day has gone by without a headline about these prices rising or falling, oil-related companies slashing capital budgets and operations, weak profits in the energy sector, and more. While U.S. consumers have benefited from lower prices at the gas pump, citizens of emerging-market oil exporters such as Brazil and Venezuela have felt the pain of living in struggling, resource-dependent economies.

Similarly, there have been “winners and losers” among the various segments of the energy business. The holdings of your fund, selected by its advisors, Wellington Management Company and Vanguard Quantitative Equity Group, were largely among the winners.

For the six months, some of the strongest performers were exploration and production companies and those who provide equipment and services to them, as rising prices spurred activity. Relative to the benchmark index, your fund benefited from the advisors’ selections among such stocks and from a double-the-benchmark stake in exploration and production companies—especially those based in North America.

 

The fund expense ratios shown are from the prospectus dated May 25, 2016, and represent estimated costs for the current fiscal year. For the
six months ended July 31, 2016, the fund’s annualized expense ratios were 0.38% for Investor Shares and 0.32% for Admiral Shares. The
peer-group expense ratio is derived from data provided by Lipper, a Thomson Reuters Company, and captures information through year-end
2015.

Peer group: Global Natural Resources Funds.

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At the other end of the spectrum, refiners and marketers, which have to pay for crude oil for their operations, generally declined. A slightly lighter-than-benchmark allocation to such companies helped the fund.

Returns for the integrated oil and gas behemoths, whose operations span exploration, production, and marketing, generally fell somewhere in between. The fund’s below-benchmark allocations here modestly held back results.

The Advisors’ Report that follows this letter provides additional details about the management of the fund during the period.

Consider rebalancing to manage your risk

After you’ve created an investment portfolio—with a diversified mix of stock, bond, and money market funds tailored to your goals, time horizon, and risk tolerance—what next?

As stocks and bonds rise or fall over time, and that portfolio drifts from its original asset allocation, you should consider rebalancing back to your targets. Just one year of outsized returns can throw your allocation out of whack.

Consider 2013, when the broad U.S. stock market returned nearly 34% and the broad taxable bond market declined. A hypothetical simple portfolio that tracked the broad U.S. market indexes and started the year with 60% stocks and 40% bonds would have ended with a more aggressive mix of 67% stocks and 33% bonds.

Rebalancing means shifting assets away from areas that have performed well toward those that have fallen behind, to restore the portfolio’s original asset allocation. That isn’t easy or intuitive, but it helps manage risk, because over time, riskier assets tend to grow faster. (For more on this, see Best Practices for Portfolio Rebalancing, at vanguard.com/ research.)

You might consider, for example, monitoring your portfolio annually or semiannually and rebalancing when your allocations shift about 5 percentage points from their targets. And be aware of the tax implications.

Keeping your asset allocation from drifting too far off target can help you stay on track with the investment plan you’ve crafted to meet your financial goals.

As always, thank you for investing with Vanguard.

Sincerely,

F. William McNabb III
Chairman and Chief Executive Officer
August 10, 2016

 

Advisors’ Report

Vanguard Energy Fund returned 21.77% for Investor Shares and 21.81% for Admiral Shares for the six months ended July 31, 2016, ahead of its benchmark index and the average return of its global natural resources peer funds. 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 period and of how their portfolio positioning reflects this assessment. These reports were prepared on August 10, 2016.

Wellington Management Company llp

Portfolio Manager:

Gregory LeBlanc, CFA,
Senior Managing Director,
Global Industry Analyst

The investment environment

Global energy equities enjoyed a strong six months. The MSCI All Country World Energy Index (net of withholding taxes) returned 18.07%, outpacing global equities, as measured by the MSCI All Country World Index, which returned almost 13%.

 

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Crude oil prices marched higher, and in May they touched $50 for the first time in 2016. The massive capital retrenchment seen over the last few quarters has taken a toll on the global oil supply. U.S. oil production continued its steady decline, and non-OPEC oil supply came under severe pressure because of a lack of sanctioned projects. Supply outages in Canada, Nigeria, Libya, and Venezuela during the second quarter only exacerbated the downward trend. In addition, OPEC supply growth seemed likely to be contained.

As the oil market realized that the supply overhang was not nearly as large as had been feared and was rapidly dissipating, oil prices and energy stocks posted strong gains. Concerns, however, have now shifted to the prospect of U.S. shale production once again flooding the market.

Our successes

Our strategy emphasizes long-term total-return opportunities from the various energy subsectors: international oils, foreign integrated oils and foreign producers, North American producers, oil services and equipment, transportation and distribution, and refining and marketing.

Security selection, particularly within U.S. exploration and production companies, lifted relative results, with Newfield Exploration, Pioneer Natural Resources, and Energen contributing notably. Our underweight exposure to refiners, a subsector that posted negative returns, also helped.

Newfield Exploration, which holds key positions in the Anadarko Basin, increased its second-quarter and full-year 2016 production guidance. The increase was driven by strong production in the Basin and benefited Newfield’s stock price. We are encouraged by the company’s improving oil well results and operating efficiencies, and we increased our position.

Pioneer Natural Resources continues to exceed production expectations, thanks to an increase in well productivity and operational efficiencies. We believe Pioneer remains a compelling investment, given its asset quality, strong balance sheet, and access to capital, all of which should help it weather commodity price volatility.

Energen, which has primary operations in the Permian, Delaware, and Midland Basins, recently buttressed its already strong balance sheet by selling its noncore assets. We maintain our position, as we believe that the market has underappre-ciated Energen’s Delaware assets and that the company could be a candidate for acquisition.

Our shortfalls

Our most significant relative detractors included our holdings of Antero Resources and our underweight exposure to Petrobras and Royal Dutch Shell. A frictional cash position also weighed on results.

Shares of Antero Resources, an independent exploration and production company, retreated slightly. We maintained our position as we believe Antero’s recent

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acquisition of Marcellus core acreage has boosted its acreage quality. The company also has well-hedged positions that should help them weather near-term volatility in natural gas prices.

Petrobras and Royal Dutch Shell posted significant gains, so our underweights weighed on relative results. The stock price of Petrobras, a Brazilian integrated oil and gas producer, surged as the company took further steps to reduce debts by selling assets. An appreciating Brazilian real further helped its cash flows. Royal Dutch Shell, a U.K.-based integrated oil and gas producer, also saw stock gains on the back of recovering oil prices. We remain cautious on both names and continue to favor producers, which we believe have greater upside.

The fund’s positioning

Overall, we still see increasing dispersion of asset quality and well results within the producer subsegment of the energy sector. This dispersion is creating valuable opportunities in select North American oil and natural gas producers. Improvements in well results in both the Permian Basin and the Anadarko Basin have driven asset value and cash-flow revisions higher for some of the companies that have tier-1 acreage. We think the improvement potential for productivity in these basins is likely underappreciated by the market.

We continue to focus on producers with a growing cost advantage, the ability to benefit from new technology, and positive revisions to the depth and quality of their future drilling inventory relative to consensus.

Vanguard Quantitative Equity Group

Portfolio Managers:

James P. Stetler, Principal

Michael R. Roach, CFA

Binbin Guo, Principal, Head of Equity
Research and Portfolio Strategies

Energy stocks returned more than 18% for the half year, a welcome departure from their double-digit decline for the previous six months. The sector outperformed the aggregate global equity market by several percentage points. The U.S. equity market bested international developed markets but lagged emerging markets.

Following historically low oil prices early this year, coordination between Russia and OPEC member countries to limit production gained traction and encouraged other nations to consider similar actions. As prices stabilized and then rose, oil companies saw some reprieve from concerns regarding their liquidity and profit margins. While Britain’s decision to leave the European Union prompted a short plunge in prices, it also highlighted the commodity’s volatility. However, the United Kingdom represents a minor portion of global demand and core oil fundamentals remained largely unchanged.

U.S. natural gas production slowed because of a large inventory buildup during last year’s tepid winter, which drove prices down and decreased drilling profitability. But natural gas demand has increased significantly over the past few years as the United States transitions away

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from coal-fired power plants. As winter approaches, prices may continue to rise, particularly if production does not increase.

Although it’s important to understand how overall portfolio performance is affected by such macroeconomic factors, our approach to investing focuses on specific stock fundamentals and portfolio characteristics. We use a disciplined selection process that compares all the stocks in our investment universe to identify those with characteristics that we believe will help them outperform over the long run.

To do this, we use a strict quantitative process that focuses on four key themes: 1) high quality—healthy balance sheets and consistent cash flow generation; 2) effective use of capital—sound investment policies that favor internal over external funding; 3) strong market sentiment—market confirmation of our view; and 4) reasonable valuation—avoidance of overpriced stocks.

Using these models, we generate a composite expected return for all the stocks we follow each day, seeking to capitalize on investor biases across the market. We then construct our portfolio with the goal of maximizing expected return while minimizing exposure to risks that our research indicates do not improve returns.

For the six months, results from our stock selection models were mixed. Our valuation and management decisions models contributed positively, but our sentiment and quality models held back results.

Our most successful holdings included WorleyParsons (+133.9%), Seadrill (+39.0%), and Subsea 7 (+81.6%).

Our overweighting Valero Energy (–21.9%), HollyFrontier (–29.7%), and Petrofac (–8.8%) held back results, as did our underweighting Petroleo Brasileiro (+202.8%) and Canadian Natural Resources (+45.6%).

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Energy Fund

Fund Profile
As of July 31, 2016

 

 

 

 

1 The expense ratios shown are from the prospectus dated May 25, 2016, and represent estimated costs for the current fiscal year. For the six
months ended July 31, 2016, the annualized expense ratios were 0.38% for Investor Shares and 0.32% for Admiral Shares.

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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.

Fiscal-Year Total Returns (%): January 31, 2006, Through July 31, 2016

For a benchmark description, see the Glossary.
Note: For 2017, performance data reflect the six months ended July 31, 2016.

Average Annual Total Returns: Periods Ended June 30, 2016
This table presents 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.

 

See Financial Highlights for dividend and capital gains information.

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Energy Fund

Financial Statements (unaudited)

Statement of Net Assets
As of July 31, 2016

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

 

 

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Energy Fund

 

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Energy Fund

 

 

• See Note A in Notes to Financial Statements.
* Non-income-producing security.
^ Includes partial security positions on loan to broker-dealers. The total value of securities on loan is $141,163,000.
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 97.4% and 4.2%, respectively, of
net assets.
2 Considered an affiliated company of the fund as the issuer is another member of The Vanguard Group.
3 Affiliated money market fund available only to Vanguard funds and certain trusts and accounts managed by Vanguard. Rate shown is the
7-day yield.
4 Includes $157,736,000 of collateral received for securities on loan.
5 The issuer operates under a congressional charter; its securities are generally neither guaranteed by the U.S. Treasury nor backed by the
full faith and credit of the U.S. government.
6 Securities with a value of $2,200,000 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

 

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

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Energy Fund

Statement of Changes in Net Assets

 

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

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Energy Fund

Financial Highlights

 

The expense ratio, net investment income ratio, and turnover rate for the current period have been annualized.
1 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.
2 Includes performance-based investment advisory fee increases (decreases) of 0.04%, 0.03%, 0.03%, 0.04%, (0.02%), and 0.01%.

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

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Energy Fund

Financial Highlights

 

The expense ratio, net investment income ratio, and turnover rate for the current period have been annualized.
1 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.
2 Includes performance-based investment advisory fee increases (decreases) of 0.04%, 0.03%, 0.03%, 0.04%, (0.02%), and 0.01%.

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. investment companies. 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. Counterparty risk involving futures is mitigated because a regulated clearinghouse is the counterparty instead of the clearing broker. To further mitigate counterparty risk, the fund trades futures contracts on an exchange, monitors the financial strength of its clearing brokers and clearinghouse, and has entered into clearing

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Energy Fund

agreements with its clearing brokers. The clearinghouse imposes initial margin requirements to secure the fund’s performance and requires daily settlement of variation margin representing changes in the market value of each contract.

Futures contracts are valued at their quoted daily settlement prices. The aggregate settlement values 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).

During the six months ended July 31, 2016, the fund’s average investments in long and short futures contracts represented 1% and 0% of net assets, respectively, based on the average of aggregate settlement values at each quarter-end during the period.

4. Repurchase Agreements: The fund enters into repurchase agreements with institutional counterparties. Securities pledged as collateral to the fund under 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. The fund further mitigates its counterparty risk by entering into repurchase agreements only with a diverse group of prequalified counterparties, monitoring their financial strength, and entering into master repurchase agreements with its counterparties. The master repurchase agreements provide that, in the event of a counter-party’s default (including bankruptcy), the fund may terminate any repurchase agreements with that counterparty, determine the net amount owed, and sell or retain the collateral up to the net amount owed to the fund. Such action may be subject to legal proceedings, which may delay or limit the disposition of collateral.

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, 2013–2016), and for the period ended July 31, 2016, 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. Securities Lending: To earn additional income, the fund lends its securities to qualified institutional borrowers. Security loans are subject to termination by the fund at any time, and are required to be secured at all times by collateral in an amount at least equal to the market value of securities loaned. Daily market fluctuations could cause the value of loaned securities to be more or less than the value of the collateral received. When this occurs, the collateral is adjusted and settled on the next business day. The fund further mitigates its counterparty risk by entering into securities lending transactions only with a diverse group of prequalified counterparties, monitoring their financial strength, and entering into master securities lending agreements with its counterparties. The master securities lending agreements provide that, in the event of a counterparty’s default (including bankruptcy), the fund may terminate any loans with that borrower, determine the net amount owed, and sell or retain the collateral up to the net amount owed to the fund; however, such actions may be subject to legal proceedings. While collateral mitigates counterparty risk, in the absence of a default the fund may experience delays and costs in recovering the securities loaned. The fund invests cash collateral received in Vanguard Market Liquidity Fund, and records a liability in the Statement of Net Assets for the return of the collateral, during the period the securities are on loan. Securities lending income represents fees charged to borrowers plus income earned on invested cash collateral, less expenses associated with the loan.

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Energy Fund

8. Credit Facility: The fund and certain other funds managed by The Vanguard Group (“Vanguard”) participate in a $3.1 billion committed credit facility provided by a syndicate of lenders pursuant to a credit agreement that may be renewed annually; each fund is individually liable for its borrowings, if any, under the credit facility. Borrowings may be utilized for temporary and emergency purposes, and are subject to the fund’s regulatory and contractual borrowing restrictions. The participating funds are charged administrative fees and an annual commitment fee of 0.10% of the undrawn amount of the facility; these fees are allocated to the funds based on a method approved by the fund’s board of trustees and included in Management and Administrative expenses on the fund’s Statement of Operations. Any borrowings under this facility bear interest at a rate based upon the higher of the one-month London Interbank Offered Rate, federal funds effective rate, or overnight bank funding rate plus an agreed-upon spread.

The fund had no borrowings outstanding at July 31, 2016, or at any time during the period then ended.

9. 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. Premiums and discounts on debt securities purchased are amortized and accreted, respectively, to interest income over the lives of the respective securities. 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.

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. The investment advisory firm 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 performance relative to the MSCI ACWI Energy Index for the preceding three years.

Vanguard provides investment advisory services to a portion of the fund as described below; the fund paid Vanguard advisory fees of $151,000 for the six months ended July 31, 2016.

For the six months ended July 31, 2016, the aggregate investment advisory fee paid to all advisors represented an effective annual basic rate of 0.14% of the fund’s average net assets, before an increase of $1,695,000 (0.04%) based on performance.

C. In accordance with the terms of a Funds’ Service Agreement (the “FSA”) between Vanguard and the fund, Vanguard furnishes to the fund investment advisory, corporate management, administrative, marketing, and distribution services at Vanguard’s cost of operations (as defined by the FSA). These costs of operations are allocated to the fund based on methods and guidelines approved by the board of trustees. Vanguard does not require reimbursement in the current period for certain costs of operations (such as deferred compensation/benefits and risk/insurance costs); the fund’s liability for these costs of operations is included in Payables to Vanguard on the Statement of Net Assets.

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Energy Fund

Upon the request of Vanguard, the fund may invest up to 0.40% of its net assets as capital in Vanguard. At July 31, 2016, the fund had contributed to Vanguard capital in the amount of $813,000, representing 0.01% of the fund’s net assets and 0.33% of Vanguard’s capitalization. The fund’s trustees and officers are also directors and employees, respectively, of Vanguard.

D. The fund has asked its investment advisor 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 six months ended July 31, 2016, these arrangements reduced the fund’s expenses by $84,000 (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 market value of the fund’s investments as of July 31, 2016, based on the inputs used to value them:

 

F. At July 31, 2016, 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.

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Energy Fund

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 six months ended July 31, 2016, the fund realized net foreign currency losses of $3,488,000, which decreased distributable net income for tax purposes; accordingly, such losses have been reclassified from accumulated net realized losses to undistributed net investment income.

The fund’s tax-basis capital gains and losses are determined only at the end of each fiscal year. For tax purposes, at January 31, 2016, the fund had available capital losses totaling $555,042,000 that may be carried forward indefinitely to offset future net capital gains. The fund will use these capital losses to offset net taxable capital gains, if any, realized during the year ending January 31, 2017; should the fund realize net capital losses for the year, the losses will be added to the loss carryforward balance above.

At July 31, 2016, the cost of investment securities for tax purposes was $7,572,565,000. Net unrealized appreciation of investment securities for tax purposes was $2,479,176,000, consisting of unrealized gains of $2,982,066,000 on securities that had risen in value since their purchase and $502,890,000 in unrealized losses on securities that had fallen in value since their purchase.

H. During the six months ended July 31, 2016, the fund purchased $1,220,098,000 of investment securities and sold $986,399,000 of investment securities, other than temporary cash investments.

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

 

J. Management has determined that no material events or transactions occurred subsequent to
July 31, 2016, that would require recognition or disclosure in these financial statements.

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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 any purchase, redemption, or account service fees described in the fund 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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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 0.38% for Investor Shares and 0.32% 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 (182/366).

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Trustees Approve Advisory Arrangements

The board of trustees of Vanguard Energy Fund has renewed the fund’s investment advisory arrangement with The Vanguard Group, Inc. (Vanguard), through its Quantitative Equity Group, and Wellington Management Company LLP (Wellington Management). The board determined that renewing the fund’s advisory arrangements was in the best interests of the fund and its shareholders.

The board based its decision upon an evaluation of each advisor’s investment staff, portfolio management process, and performance. The trustees considered the factors discussed below, among others. However, no single factor determined whether the board approved the arrangements. Rather, it was the totality of the circumstances that drove the board’s decision.

Nature, extent, and quality of services

The board reviewed the quality of the fund’s investment management services over both the short and long term, and took into account the organizational depth and stability of each advisor. The board considered the following:

Vanguard. Vanguard has been managing investments for more than three decades. The Quantitative Equity Group adheres to a sound, disciplined investment management process; the team has considerable experience, stability, and depth. Vanguard has managed a portion of the fund since 2005.

Wellington Management. Founded in 1928, Wellington Management is among the nation’s oldest and most respected institutional investment managers. The investment team uses a bottom-up approach in which stocks are selected based on the advisor’s estimates of fundamental investment value. Fundamental research focuses on the quality of a company’s assets, its internal reinvestment opportunities, and management quality. The firm has advised the fund since the fund’s inception in 1984.

The board concluded that each advisor’s experience, stability, depth, and performance, among other factors, warranted the continuation of the advisory arrangements.

Investment performance

The board considered the short- and long-term performance of the fund, including any periods of outperformance or underperformance relative to a benchmark index and peer group. The board concluded that the performance was such that the advisory arrangements should continue. Information about the fund’s most recent performance can be found in the Performance Summary section of this report.

Cost

The board concluded that the fund’s expense ratio was well below the average expense ratio charged by funds in its peer group and that the fund’s advisory fee rate was also well below its peer-group average. Information about the fund’s expenses appears in the About Your Fund’s Expenses section of this report as well as in the Financial Statements section, which also includes information about the fund’s advisory fee rate.

The board did not consider profitability of Wellington Management in determining whether to approve the advisory fee, because Wellington Management is independent of Vanguard, and the advisory fee is the result of arm’s-length negotiations. The board does not conduct a profitability analysis of Vanguard, because of Vanguard’s unique “at-cost” structure. Unlike most other mutual fund management companies, Vanguard is owned by the funds it oversees, and produces “profits” only in the form of reduced expenses for fund shareholders.

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The benefit of economies of scale

The board concluded that the fund’s shareholders benefit from economies of scale because of breakpoints in the fund’s advisory fee schedule for Wellington Management. The breakpoints reduce the effective rate of the fee as the fund’s assets managed by Wellington Management increase. The board also concluded that the fund’s at-cost arrangement with Vanguard ensures that the fund will realize economies of scale as it grows, with the cost to shareholders declining as the fund’s assets managed by Vanguard increase.

The board will consider whether to renew the advisory arrangements again after a one-year 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 (for bonds), its actual income (for asset-backed securities), 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. A fund’s total annual operating expenses expressed as a percentage of the fund’s average net assets. The expense ratio includes management and administrative expenses, but does not include the transaction costs of buying and selling portfolio securities.

Foreign Holdings. The percentage of a fund represented by securities 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.

Benchmark Information

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.

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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 198 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, the Vanguard Municipal Bond Funds, and the Vanguard State Tax-Exempt Funds.

 

 

 

 

Semiannual Report | July 31, 2016

Vanguard Precious Metals and Mining Fund

 

Vanguard’s Principles for Investing Success

We want to give you the best chance of investment success. These principles, grounded in Vanguard’s research and experience, can put you on the right path.

Goals. Create clear, appropriate investment goals.

Balance. Develop a suitable asset allocation using broadly diversified funds. Cost. Minimize cost.

Discipline. Maintain perspective and long-term discipline.

A single theme unites these principles: Focus on the things you can control.

We believe there is no wiser course for any investor.

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.
About the cover: Pictured is a sailing block on the Brilliant, a 1932 schooner docked in Mystic, Connecticut. A type of pulley, the
sailing block helps coordinate the setting of the sails. At Vanguard, the intricate coordination of technology and people allows
us to help millions of clients around the world reach their financial goals.

 

Your Fund’s Total Returns

 

 

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Chairman’s Letter

Dear Shareholder,

After an extended period of steep declines, the precious metals and mining sector rebounded dramatically in the six months ended July 31, 2016. Rising precious metals prices and a spike in demand for gold sent the industry soaring.

In this environment, Vanguard Precious Metals and Mining Fund returned 102.54%. The fund easily outpaced its benchmark, the Standard & Poor’s Global Custom Metals and Mining Index (+82.95%), but lagged the average return of its peers (+117.30%).

Although your fund’s most recent result is undoubtedly impressive, it should nevertheless be viewed with extreme caution. In this highly volatile segment, performance can turn quickly, and the peaks and valleys can be extreme. Take for example fiscal years 2008, 2009, and 2010: The fund returned 33.97%, –60.16%, and 77.75%, respectively. More recently, the fund has recorded negative returns for the last four fiscal years.

These tendencies are consistent with the dynamic variables inherent to the industry, including dramatic price spikes or declines, limited resources, government regulation, and geopolitical tumult—all of which have affected metals and mining stocks in recent years. Keep in mind also that the sector is a narrow segment, accounting for less than 5% of global stock market capitalization.

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Because of its risk characteristics, the fund should be considered a complement to an already diversified portfolio with a long time horizon.

U.S. stocks continued to surge despite signs of uncertainty

U.S. stocks proved resilient over the half year, returning about 14%, although the global environment was far from tranquil.

Stocks tumbled after the momentous June 23 decision by U.K. voters to leave the European Union. But the market quickly recovered. Worries about the effects of “Brexit” on trade and economic growth seemed to diminish as expectations rose that major central banks would be responsive to any fallout.

International stocks also performed well, returning nearly 12%. European stocks finished solidly but still lagged as the Brexit referendum hit close to home. Emerging-market stocks and those from developed Pacific markets recorded double-digit returns.

Bonds drew support given economic factors and low yields

The broad U.S. bond market advanced in each of the six months en route to returning 4.54%. With the stock market volatile at times, the global growth pace uncertain, and inflation low, investors sought safe-haven assets. Foreign investors flocked to U.S. Treasury debt amid exceptionally low or negative yields abroad.

 

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The yield of the 10-year Treasury note closed July at 1.45%, down from 1.98% at the end of January. (Bond prices and yields move in opposite directions.)

The Federal Reserve has held its target for short-term interest rates at 0.25%–0.5% since raising it by a quarter percentage point last December. Money market funds and savings accounts stayed restrained by these historically low rates.

International bond markets (as measured by the Barclays Global Aggregate Index ex USD) returned 12.31%. A number of foreign currencies strengthened against the dollar, but the bond returns were robust even without this currency benefit.

A larger stake in gold-oriented firms led to the fund’s triple-digit advance

Your fund invests in companies that are involved in the mining of, or exploration for, precious and rare metals and minerals. As I mentioned, the embattled sector experienced a significant rebound during the fiscal half year, amid increased demand and higher prices. Gold, in particular, did well.

Although prices of some other precious metals, such as silver (+42.6%) and platinum (+31.9%), had larger advances, gold (+20.8%) has a much larger market share, and an increase in its price can provide a huge boost to the precious metals and mining industry, just as it did over the period.

The fund expense ratio shown is from the prospectus dated May 25, 2016, and represents estimated costs for the current fiscal year. For the
six months ended July 31, 2016, the fund’s annualized expense ratio was 0.44%. The peer-group expense ratio is derived from data provided
by Lipper, a Thomson Reuters Company, and captures information through year-end 2015.

Peer group: Precious Metals Equity Funds.

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Demand for gold, long considered a safe haven during times of financial turmoil, surged as investors sought perceived safety amid uncertainty in the equity and fixed income markets. Gold-oriented stocks, such as those held by your fund, reaped the rewards.

Historically, relative to its benchmark and peers, your fund has been underweighted in stocks of companies whose businesses are closely tied to gold and other precious metals. More recently, the fund’s advisor, M&G Investment Management, has increased the portfolio’s holdings in this category above those of the benchmark. This change in allocation provided a significant boost to the fund’s absolute return, as well as to its performance relative to the index.

To accommodate the fund’s larger position in precious metals-related companies, the advisor trimmed the position in diversified metals and mining stocks—another move that helped boost performance in comparison to the benchmark. On average, these stocks accounted for about 15% of the fund’s holdings, compared with an average of about 40% in the benchmark. Despite producing generally strong results, diversified metals and mining stocks lagged the triple-digit returns that were common among gold stocks for the period.

For a more detailed discussion of the management of the fund, please see the Advisor’s Report that follows this letter.

Consider rebalancing to manage your risk

Let’s say you’ve taken the time to carefully create an appropriate asset allocation for your investment portfolio. Your efforts have produced a diversified mix of stock, bond, and money market funds tailored to your goals, time horizon, and risk tolerance.

But what should you do when your portfolio drifts from its original asset allocation as the financial markets rise or fall? Consider rebalancing to bring it back to the proper mix. Just one year of outsized returns can throw your allocation out of whack. Take 2013 as an example. That year, the broad stock market (as measured by the Russell 3000 Index) returned 33.55% and the broad taxable bond market (as measured by the Barclays U.S. Aggregate Bond Index) returned –2.02%. A hypothetical portfolio that tracked the broad domestic market indexes and started the year with 60% stocks and 40% bonds would have ended with a more aggressive mix of 67% stocks and 33% bonds.

Rebalancing to bring your portfolio back to its original targets would require you to shift assets away from areas that have been performing well toward those that have been falling behind. That isn’t easy or intuitive. It’s a way to minimize risk rather than maximize returns and to stick with your investment plan through different types of markets. (You can read more about our approach in Best Practices for Portfolio Rebalancing at vanguard.com/research.)

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It’s not necessary to check your portfolio every day or every month, much less rebalance it that frequently. It may be more appropriate to monitor it annually or semiannually and rebalance when your allocation swings 5 percentage points or more from its target. It’s important, of course, to be aware of the tax implications. You’ll want to consult with your tax advisor, but generally speaking, it may be a good idea to make any asset changes within a tax-advantaged retirement account or to direct new cash flows into the underweighted asset class.

However you go about it, keeping your asset allocation from drifting too far off target can help you stay on track with the investment plan you’ve crafted to meet your financial goals.

As always, thank you for investing with Vanguard.

Sincerely,

F. William McNabb III
Chairman and Chief Executive Officer
August 12, 2016

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Advisor’s Report

Vanguard Precious Metals and Mining Fund returned 102.54% for the six months ended July 31, 2016. It finished significantly ahead of its customized benchmark, which returned 82.95%, but lagged the 117.30% average return of its peers.

The markets

Global stock markets recovered from a troubled start to deliver positive returns for the six months. Despite turbulence surrounding the United Kingdom’s shocking vote in June to leave the European Union, investors’ appetite for risk quickly recovered, and markets resumed their upward momentum to end the period at the highest level of 2016.

At the beginning of the period, investors were worried about a potential U.S. recession and the strength of Chinese economic growth. Weak commodity prices also dampened investor sentiment. Confidence gradually improved as robust data suggested that the U.S. economic recovery was gaining momentum, although the Federal Reserve held off raising interest rates again (following its first hike in December 2015) in light of uncertainty. China’s economy appeared to stabilize, arguably with the support of government stimulus measures.

Precious metals performed well, with the prices of gold and silver surging to their highest levels since 2014. Gold benefited from investors’ demand for a perceived “safe haven” amid worries about Brexit, a potential banking crisis in Italy, and the prospect of persistent low—or, in some cases, negative—interest rates, coupled with quantitative easing programs in a number of economies.

Against the backdrop of rising commodity prices, mining companies—and precious metals producers in particular—experienced significant gains and were top performers.

The fund’s performance

After a challenging couple of years for commodities and mining companies, we were pleased to see such a strong rebound in share prices over the period. This helped the fund deliver an impressive absolute return of more than 100%. On a relative basis, the fund outperformed its customized benchmark by nearly 20 percentage points. The fund was a bit behind its precious metals fund peers, which are mainly composed of pure precious metals stocks. Your fund includes a few diversified mining companies, and it has less exposure to the more speculative names.

The main driver of the fund’s outperformance relative to the benchmark was its allocation to precious metals companies, which were by far the best-performing category. First Majestic Silver and Hochschild Mining both returned over 400%. Hochschild benefited from higher silver prices and better-than-expected operational performance, particularly at its new mine in Peru, as well as an improved political situation in Argentina with the election of President Mauricio Macri at the end of 2015.

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B2Gold, a Canadian gold producer with assets in Africa, was another leading contributor as its share price bounced back after a weak period. Investors had been concerned that the miner would run into difficulties by developing a new project when gold prices were low. But with gold prices rising, we are more comfortable about the company’s financial position, and we believe the mine is an attractive asset. Similarly, investors’ concerns about the amount of leverage Yamana Gold had on its balance sheet during the period of declining prices have largely been set aside.

Alamos Gold, Kaminak Gold, and Acacia Mining also made positive contributions. The share price of Kaminak, a junior miner, was boosted by a takeover approach from Goldcorp, one of the world’s largest gold producers, which is also held in the portfolio.

Relative performance also was enhanced by avoiding U.K.-listed miner Rio Tinto, which, despite making gains, significantly underperformed the benchmark. Similarly, being underweighted in BHP Billiton added value.

In contrast, the biggest detractor from relative performance was the fund’s large overweight holding in Dominion Diamond. The diamond sector has suffered lately on concerns about a slowdown in consumer sentiment, especially for luxury goods. Dominion’s share price fell during the period after the company reported disappointing results. The diamond miner also was hurt by a fire at one of its mines, which led to a reduced production forecast.

One of our biggest disappointments was the U.K.-listed mining company Anglo American, which we had invested in for its De Beers diamond exposure. The stock was hurt by weakness in the diamond market, and we sold the position in its entirety. We also sold our holding in Petra Diamonds.

With investors preferring precious metals during the period, the fund’s large above-index position in Canadian copper miner Nevsun Resources also detracted from performance relative to the benchmark. Similarly, fertilizer company PotashCorp was a notable detractor.

Meanwhile, not holding some of the more speculative gold mining companies also hurt relative results, as they were among the period’s top performers.

Purchases and sales

We added a number of gold producers to the portfolio, including Barkerville Gold Mines and Kinross Gold. We remain positive on gold producers over diversified metals and mining companies, given the heightened market risks. Furthermore, we believe that gold companies are benefiting from lower energy costs and higher gold prices, together with a lower cost base, after recent cost-cutting initiatives. Combined, these factors should deliver higher cash flows over the next few years.

We also initiated a position in U.S.-based agribusiness Bunge. The company’s operations are linked to the agricultural commodity cycle, and we purchased the shares on an attractive valuation at the low end of this cycle. We regard Bunge as a

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well-managed, cash-generative, geographically diverse business with a strong balance sheet.

In terms of sales, we closed out our position in Kirkland Lake Gold after the chief executive was replaced. We attach great importance to company management, strategy, and execution, and we will assess the new executive.

As previously mentioned, we sold our holdings in Anglo American and Petra Diamonds; our position in Lakeshore Gold was dissolved after the company was acquired.

Looking ahead

We continue to believe that the precious metals and mining stocks are the most attractive, and we remain overweighted in this subsector. The diversified miners are still going through the restructuring process and, in this respect, continue to lag the gold miners by about 21/2 years in the commodities cycle. For this reason, we are significantly underweighted in diversified metals and mining stocks compared with the benchmark.

We maintain that 2016 will be a good year for gold. A number of heightened market risks continue, including the forthcoming election in the United States, the troubled European banking system, and negative interest rate policies. Gold companies are benefiting from lower costs (specifically, energy) and a gold price that’s risen 25% since the start of 2016, which should lead to growth in free cash flow and a positive free cash flow yield for the next couple of years.

We will continue to implement our investment philosophy and process: maintaining a long-term approach and identifying high-quality companies with strong management teams, best-in-class assets, and costs that compare favorably with those of their competitors.

Jamie J. Horvat
Portfolio Manager

M&G Investment Management Limited

August 11, 2016

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Precious Metals and Mining Fund

Fund Profile
As of July 31, 2016

 

 

 

 

1 The expense ratio shown is from the prospectus dated May 25, 2016, and represents estimated costs for the current fiscal year. For the six months
ended July 31, 2016, the annualized expense ratio was 0.44%.

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