Principal Is Branching Out, But Not Too Far

This retirement-plan heavyweight has a solid--but not industry-leading--culture.

Morningstar recently issued a new Stewardship Grade for Principal. 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, for which Principal receives a C. 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).

The Principal funds are expanding into new areas and trying to craft their own identity beyond their roots in insurance-retirement conglomerate Principal Financial Group. There's been quite a bit of progress on that front, and Principal is now one of the 20 largest open-end fund families by assets, thanks to expanded distribution and the popularity of some of its new funds. The Principal fund lineup looks quite different than it did a decade ago, but it's still something of a work in progress, and it doesn't really stand out from the pack in terms of stewardship.

Principal Financial Group originated as a life insurance company, and insurance still makes up a big part of its business. In the 1940s, the firm began administering pension and retirement plans, and it is now one of the largest operators of 401(k) and other defined-contribution retirement plans for small- and midsized U.S. businesses. PFG's asset-management arm, including the mutual fund lineup, has long had close ties to these other two businesses.

As of June 30, 2013, it had $451 billion in assets under management, most of which was in pension and retirement portfolios (tied to the firm's retirement-services arm) and fixed and variable annuities (tied to the firm's life-insurance arm). About $100 billion was in the Principal mutual funds, about double what was in the funds four years earlier. The funds have always been used in Principal's retirement portfolios, and from 2000 to 2005 there was a parallel lineup of clone mutual funds designed specifically for use in investors' retirement portfolios. Now there is a single lineup of funds having as many as 11 different share classes, including five for retirement accounts and three for retail investors.

One way Principal has expanded its asset base and investment capabilities is by buying up niche investment shops, which now also manage a good chunk of the firm's assets. These "affiliated" firms 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); and Morley Financial Services, a stable-value investment firm (bought in 2007). Principal Financial has also bought many overseas investment firms over the past 20 years, mainly 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.

In addition to these affiliated firms, Principal has also expanded the number of outside subadvisors who manage the money in its portfolios, something that used to be done mainly by the firm's in-house asset-management arm, Principal Global Investors. In keeping with its institutional roots, PGI has

traditionally tended to take a somewhat conservative, index-conscious approach in which risk controls play an important role. Now, however, roughly 30% of Principal's assets under management are managed by outside subadvisors, with a wider variety of strategies. Most of these outside subadvisors run funds that are mostly or entirely used in funds of funds such as the Principal LifeTime target-date funds, where the percentage of assets managed by outside subadvisors went from 20% in 2007 to 50% in 2010. The retail-oriented funds are mostly still run by PGI, Edge, and other affiliates, but one exception is the "portfolio completion strategies" that the firm has launched in recent years:  Principal Global Diversified Income   PGBAX  (launched in 2008),  Principal Diversified Real Asset   PRDAX  (2010), and Principal Global Multi-Strategy  PMSAX  (2011). These funds are used in the target-date funds but also sold in retail shares, and they're managed by a combination of Principal affiliates and external subadvisors. They've become very popular, with Principal Global Diversified Income being the firm's biggest fund as of the end of 2013, with $8 billion in assets.

The purchase of Edge Asset Management in 2006 brought with it not only the former WM funds, a dozen of which were integrated into the Principal lineup, but Washington Mutual's fund distribution infrastructure. Previously, the Principal funds were distributed only through proprietary channels connected with the firm's insurance and retirement businesses, but now almost half of their sales are through banks, large brokerage firms, and registered investment advisors, giving them a much bigger retail presence. This enhanced distribution network is a key part of Principal's efforts to become a bigger player in the mutual fund world, both through organic growth, including the launching of new funds, and through more purchases of investment boutiques. The firm says it's still looking to buy boutiques that have good investment capabilities but could use better distribution.

There are risks inherent in the expansion strategy Principal is pursuing, such as the potential for an emphasis on gathering assets at the expense of investment performance. There is something of a sales focus at Principal, as one might expect for a firm in expansion mode, but for the most part Principal has paid attention to investment quality as it has expanded the fund lineup, and that expansion has come at a reasonable pace. While the firm launched 18 new funds between late 2007 and the end of 2013--most recently Principal Opportunistic Municipal  PMOAX , Principal Blue Chip  PBCKX , Principal Global Opportunities  PGOIX , and Principal LifeTime 2060  PLTZX --it also merged away 18 funds during that period, so that the number of funds in the lineup remained the same. The boutiques the firm has bought are mostly pretty good ones, and it has hired external subadvisors mainly for areas where Principal's internal capabilities are weak, thus raising the quality of the whole lineup. Even so, the lineup currently looks rather middling overall, with some strong funds offset by some weaker ones. As of mid-December 2013, one fund in the lineup ( Principal MidCap   PEMGX ) had a Morningstar Analyst Rating of Silver, while all the others with ratings were Neutral. In terms of the Morningstar Rating (the star rating), there were two 5-star funds (including MidCap), 15 with 4 stars, 27 with 3 stars, 13 with 2 stars, and one with 1 star.

Category: Financial services

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