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Large cap growth funds have taken quite a bit of a hit this year. With huge net outflows, this category of mutual funds has told us something rather interesting: investors have no faith in domestic equities. And this makes a bit of sense; with economic news as bleak as it has been, questionable fiscal policy and, of course, the doom and gloom that peppers virtually ever media outlet, investing in mutual funds of any type must seem like a risky proposition. Period.

The reality is that equity funds have indeed performed well, the key is finding the right category (e.g. domestic, international, etc.), capitalization (e.g. small cap, mid cap, large cap) and focus, or asset concentration. This final point (focus) has become our theme, one where the underlying assets are seen as a better determinant to a mutual fund’s future success than outdated, historical performance records.

With that in mind, we often publish reviews of what other parties see as particularly strong and high-potential funds. We love Morningstar for their transparency and in-depth fund reporting (they are the best website out there, hands down). But there are other sources as well, and none of them really get into what powers returns. While they might look at the end product, they ignore the powerplant that propels fund returns from one year to the next.

And that brings us to PRIMECAP Odyssey Growth fund (POGRX), a five-star fund as rated by Morningstar and a fund that, for the most part, offers powerful returns. Although we have just 5 years of data available to us, this large cap growth fund has underperformed the S&P 500 twice in that period… less than 1%, though (so go ahead and call it a matched performance). Its worst year was in 2007 when it returned 4.9% versus the S&P 500′s 5.5%, a 0.6% difference. How can you argue with that.

And how can an investor argue with 40.95% in 2009, beating the S&P 500 by 14.5% and its peer group by 5.26%? Yes, there were some large cap growth funds that performed better, but you really have to dig to find them… and even then, the chance that they are taking on more risk to achieve those returns negates those short-term benefits.

With PRIMECAP, you are getting a well diversified portfolio of 116 individual securities, most of them (about 78%) domestic. What makes this particular fund stand apart from others we have reviewed recently is its sector weightings. With 40% of its $1.5 Billion in Healthcare, this mutual fund is way more over-exposed than its category average of 12.9%. This is a big position, a clear bias.

The second largest sector exposure is IT Hardware at 14.2% (versus its peer average at 17.3%), and its third largest is Software at 9.3% (versus its peer average at 6.7%). In neither of these secondary weightings do we wonder all that much; their deviation from the peer group is muted compared to the big leap of faith in Healthcare. Often, a big sector bias like this is offset by how the underlying assets are invested. Not the case here…

Top Holdings

The Top 5 Holdings are all Healthcare. Of the Top 10 holdings, 7 are Healtchare stocks, so we will look at the top 3, all of which are Healthcare, but which are based in different countries.

Crucell NV at 5% of Holdings, YTD Return of 60.9%

Based in the Netherlands, this solid performer has generated a huge return for this equity fund. As a well diversified company, Crucell is involved in creating technology that helps improve the development of drugs (its proprietary technology is known in the as PER.C6); it has a strong vaccine line that it built through acquisition; it has drugs and treatments in various stages of development, including an HIV product that they are working with Harvard Medical School on.

Equally interesting is that this fund has added considerably to this position, roughly 26% as of the last reporting.

Amgen at 3.46% of Holdings, YTD Return of 1.29%

While Amgen, a US company, has not performed to the same tune as Crucell, Amgen is considered a global leader in drug production. It has a fairly healthy pipeline, a decent product offering where patents are still a few years from expiring. This is another position that the fund has added to, roughly 10% as of the last reporting date.

Eli Lilly at 2.4% of Holdings, YTD Return of 3.72%

Eli Lilly represents the fund’s 5th largest holding at 2.4% of assets and despite a fairly muted YTD return, this is one of the few holdings that pays a considerable dividend. With a yield of 5.5%, the fund is achieving some income here… more importantly, Eli Lilly is seen in the industry as an innovator which may be by default given the expiration of several patents over the next three years which many analysts see as potentially damaging for this company. This also poses the biggest risk to the company’s returns.

Other key holdings

This equity fund has fairly significant holding in Google (2.3% of holdings) one of the top growth plays out there. Interestingly, another key holding is Electronic Arts (2.07% of holdings), a leading game software developer. We expect to see additional acquisitions here, but even without that type of growth Electronic Arts is among the leaders in this segment. Another worthwhile investment is Research in Motion where the fund has recently purchased enough shares to get the holding at 1.88% of holdings. This seems like a contrarian position to take in a security that could be entering the maturity stage of its life.

Top Holdings Reviewed

If a mutual fund’s top holdings are indeed like the powerplant that propels its returns, then I understand now how those automotive journalists would have felt that day when they first opened the hood to a vehicle and stared at an electric motor. Like them, I am looking at a vehicle, in this case a strong equity fund with solid returns, bright management and everything else that makes a mutual fund a mutual fund. But when I peer under its hood, I see something that I would not normally see — a huge weighting in Healthcare, a large concentration in this same sector as its top holdings are almost exclusively in that sector as well. Yes, it is strange. But like that electric motor, it is also very thrilling.

Who Should Own This Fund?

The PRIMECAP Odyssey Growth Fund is not for everyone. Most advisors will see this, but if you are doing your mutual fund investing on your own, keep in mind the high concentration in Healthcare. While those underlying Healthcare holdings are quite different, they do rely on a lot of the same fundamentals, which translates into greater risk.

This is not a bad mutual fund. To the contrary, it is a welcome alternative to Vanguard PRIMECAP, although it costs a little more with a 0.71% expense ratio versus 0.40%, and it turns over its portfolio more than 3 times as often (12.5% vs 4%). But unlike the Vanguard PRIMECAP, this fund is not closed. All you need is a $2,000 minimum investment.

For conservative investors, we recommend limiting exposure to roughly 1/3 of core equity holdings, paying particular attention to the total portfolio’s Healthcare exposure. For example, holding this equity fund in conjunction with Vanguard Dividend Growth Fund will make less sense than holding it with the Ivy Asset Strategy fund. The former holds Healthcare in its top 3 sector holdings and the latter does not. (Of course, there are many different combination options that you can choose from, but you get the idea; stick to something with just a little, or no Healthcare weightings so that your exposure is mitigated).