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Principal’s Complex Growth Plan Reveals a Muddled Culture

Principal Funds continues to grow on multiple fronts, but its core identity remains elusive.

Michael Holt, CFA, 05/05/2015

Morningstar recently issued a new Stewardship Grade for Principal Funds. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is a C. What follows is Morningstar's analysis of the firm's corporate culture. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to subscribers of Morningstar's software for advisors and institutions: Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

Principal Funds’ leadership remains steadfast in its multiyear effort to establish its identity as a top-tier asset manager. The firm has begun to see the fruits of this effort as its stake in open-end mutual fund assets has grown to approximately $110 billion as of Dec. 31, 2014, placing it among the largest U.S.-based fund families in terms of assets under management. The firm has doubled its mutual fund assets since the end of 2010, bolstered through market appreciation and inflows. While the firm’s growth is apparent, it’s not clear whether Principal Funds can carve out a distinct identity within its storied parent company and an ultracompetitive industry.

Principal Financial Group--the parent company of Principal Funds--began as a life insurance company in 1879, and insurance still represents a significant part of its business. The firm began administering pension and retirement plans in the 1940s and remains a major player in the defined-contribution recordkeeping industry. As can be expected, the firm’s asset-management effort, including its mutual fund offerings, has close ties to its insurance and retirement lines of business. For instance, as of Sept. 30, 2014, Principal Financial Group reported that nearly half of its roughly $510 billion in assets stem from its Principal Retirement & Investor Services business.

Within the Principal Funds’ lineup are three different management approaches: Homegrown, affiliated firms, and external subadvisors. Such a structure isn’t unusual among large asset managers that have grown via bolt-on acquisitions to serve a wide-ranging client base. This structure, however, makes it difficult to maintain a single corporate culture. Principal must rely on the individual parts of its asset-management structure to consistently put its fundholders’ best interests before its own corporate interests. While there are glimmers of strong corporate cultures among the distinct areas of Principal Funds, the units do not collectively demonstrate a corporate culture that exceeds the industry standard. Much of the investment lineup fails to stand out or has been constructed with assets in mind.

Principal Global Investors now consists of 14 boutique firms that collectively run the gamut of fund assets. Three of those boutiques are homegrown: Principal Global Equities, Principal Global Fixed Income, and Principal Real Estate Investors. Their roots trace back to Principal Life Insurance Company’s investment department. These teams maintain a heavy presence in Des Moines, Iowa, where Principal Financial Group is headquartered. They manage 23 of the firm’s 56 mutual funds, excluding the target-date funds, and the homegrown funds account for roughly 40% of the firm’s mutual fund assets.

Although the homegrown teams run the most assets of the three approaches and have sufficient resources, few of their strategies stand out as exceptional, and the corporate culture varies from team to team. Principal MidCap PEMGX earns a Morningstar Analyst Rating of Silver, but that is the only fund in this group that receives a medal from Morningstar. Bill Nolin has been at the helm of the fund since 2000, and his successful long-term track record caught investors’ attention. The fund has grown to over $10 billion in assets--the firm’s second-largest fund--and closed to new investors in August 2013. Nolin’s large-cap version of the strategy--Principal Blue Chip PBLAX--has seen healthy inflows from investors since its mid-2012 inception and now holds over $1 billion in assets. Nolin has a dedicated team that consists of four research analysts and comanager Tom Rozycki. The distinct team structure results in an assortment of investment cultures.

Of the homegrown strategies, Principal Bond & Mortgage Securities PRBDX saw the largest inflows over the past year, but that was largely attributable to receiving assets from the liquidation of PIMCO-managed Principal Core Plus Bond I in early 2015. Two real estate strategies--Principal Global Real Estate Securities POSAX and Principal Real Estate Securities PRRAX--are the only other strategies that saw notable inflows over the past year.

Principal also has expanded its asset base and investment capabilities through the acquisition of niche investment shops. These affiliated shops manage 17 mutual funds that represent roughly a fourth of the firm’s mutual fund assets. They include Spectrum Asset Management, a leading investor in preferred securities (bought in 2001); Post Advisory Group, a high-yield bond shop (bought in 2004); Columbus Circle Investors, a growth-equity shop (bought in 2005); Edge Asset Management, formerly WM Advisors, the mutual fund arm of Washington Mutual (bought in 2006); Morley Financial Services, a stable-value investment firm (bought in 2007); Finisterre Capital, a London-based emerging-markets shop (bought in 2011); Origin Asset Management, a London-based global equity firm (bought in 2011); and Liongate Capital Management, an alternatives boutique (bought in 2013).

Each shop continues to operate and execute its investment process autonomously, allowing them to maintain distinct investment processes. They are generally a reputable bunch, but few stand out as best-in-class. From a mutual fund perspective, Edge and Spectrum have accumulated the most assets among affiliates. Morningstar’s analyst coverage of these strategies is limited, but of the three affiliated funds that receive ratings, none earn a Morningstar Analyst Rating higher than Neutral.

These acquisitions do not fully capture Principal Financial Group’s pursuit of global growth. It has bought multiple overseas investment firms over the past 20 years, including in Asia and Latin America; these overseas operations have been a big driver of the larger firm's growth, but they are mostly part of Principal International and not directly connected to the U.S. mutual funds.

Principal has also made headway with its external subadvisor mutual fund offerings. The firm has 16 funds--excluding the target-date series--managed completely or predominantly by external subadvisors. These funds account for roughly 35% of the firm’s mutual fund assets. Principal Management Corporation--separate from Principal Global Investors--conducts investment manager research and prudently selects subadvisors. They have hired a mix of esteemed players like BlackRock, Causeway, and T. Rowe Price to run mandates for Principal in the same fashion as their proprietary funds that receive a medal from Morningstar analysts. At the same time, Principal Management Corporation has selected firms found off the beaten path, such as Emerald Advisers and Sawgrass Asset Management.

In multiple cases, these externally subadvised strategies compete directly with a homegrown management team or an affiliated firm. It’s not uncommon for retirement-plan recordkeepers to create both internally and externally managed funds for clients; plan sponsors increasingly want to choose from a broad menu of industry-leading funds. But the strategy also suggests a lack of confidence in the homegrown or affiliated teams.

Not all externally subadvised strategies are duplicative. Principal has seen particular success with its differentiated “portfolio completion strategies” that it launched in recent years: Principal Global Diversified Income PGBAX (launched 2008), Principal Diversified Real Asset PRDAX (launched 2010), and Principal Global Multi-Strategy PMSAX (launched 2011). Those three funds combine to over $18 billion in assets, and Principal Global Diversified Income is the firm’s biggest fund with over $11 billion in assets. They were also Principal’s top three funds in terms of inflows over the past year, and these flows have come from both retail and institutional investors. All three funds have also gained assets as sizable underlying components within the firm’s growing target-date series. Principal Diversified Real Asset earns a Morningstar Analyst Rating of Bronze, whereas the other two are rated Neutral.

Principal’s target-date series invest across all three of its management approaches and remain a significant source of assets for the underlying funds. The LifeTime series, which earns a Morningstar Analyst Rating of Bronze, collectively held more than $25 billion in assets at the end of 2014. This represented approximately 23% of the firm’s fund assets and made it the target-date industry’s sixth-largest series in terms of mutual fund assets. The series’ traction has been tied to Principal’s robust defined-contribution recordkeeping business. Principal launched LifeTime Hybrid, which combines active and passive management, in late 2014 to better compete with lower-cost target-date offerings.

Principal recently made some shifts in leadership, but there’s good reason to expect that the current leaders will continue down the same road, with the retirement recordkeeping business continuing to influence the fund lineup here. In February 2015 Principal announced that Nora Everett, who was serving as president and CEO of Principal Funds, would transition to become president of Principal Retirement & Investor Services. (She remains chairman of Principal Funds.) As part of the restructuring, Principal Funds now falls within Principal Global Investors--led by Jim McCaughan--in lieu of Principal Retirement & Investor Services. Mike Beers is now leading Principal Funds. He worked alongside Everett prior to the changes, providing some continuity in leadership.

Although Principal Fund’s growth effort can be expected to remain intact, its core identity and corporate culture remain elusive. The firm offers intriguing funds here and there, but they don’t reflect an overarching prowess in any given area. Less than a third of Principal’s funds have both survived and outperformed peers on a risk-adjusted basis over the past decade. Principal’s results are in line with those at Fidelity, a chief rival in the retirement-plan market, but fall far short of competitors T. Rowe Price and Vanguard, both of which have Morningstar Risk-Adjusted Success Ratios of 80% for the 10-year period.

To Principal’s credit, the firm treads consciously into new mandates rather than flooding the market with trendy funds. However, its unusual mix of homegrown, affiliated, and external management teams suggests the firm’s top priority is growing assets rather than creating a culture that’s laser-focused on superior outcomes for fundholders. Principal’s corporate culture is unlikely to harm fundholders, but it doesn’t rise above the industry standard.

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for Principal Funds. See Morningstar's Stewardship Grade methodology on our corporate website.

 

Michael Holt, CFA, is a senior stock analyst with Morningstar.
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