Keeping the focus sharp

The main business of Principal Global Investors, a US asset management company with headquarters in Des Moines, is pension funds. Principal manages the assets of 10 of the 25 largest pension funds in the US and more than two thirds of its $180bn (€134bn) assets under management belong to pension funds.

This has shaped its business approach, says Nick Lyster, who took over as chief executive of Principal's European arm in London-based European operations, Principal Global Investors Europe, at the end of last year.

"Our core business is very much pension funds, and I think that's important in understanding our culture," he says. "As a result, there is a certain fiduciary element that runs through how we manage money. The approach is long term, fundamental and rational. If there's anything that's common across most of our asset classes and specialisms it is that approach."

Lyster, former head of European sales and marketing at Principal Global Investors Europe since 2002, leads a team of 27 people, 15 of whom are involved in fund management. Principal's London-based operations, which began four years ago, now comprise currency management, European and emerging market equities and European fixed income.

The team moved from Sydney to London three years ago. "Our currency team has a 12 year track record and an eight year absolute track record. We moved because London is very much seen as the centre of currency management," says Lyster.

"In the last two years we have seen growing interest in currency management from consultants and pension funds and we've seen a big growth in our business.

"Where our competitive advantage lies is in our style. We use a judgemental style while most of the industry uses a systematic, trend-following style. Therefore, we blend well with other managers in a multi-manager arrangement."

The European equities team dovetails into the international team since the head of European equities is also co-head of EAFE equities, a significant class for us in the US. "Although they are based here we would really consider them as a global based team," Lyster says.

Principal Global Investors Europe is currently expanding its complement, particularly in the European fixed income area, he says. "The European fixed income team will be growing significantly over the next year and we expect the European office to have doubled in size by the end of 2007."

Until recently, Principal was perceived chiefly as a manufacturer of core fixed income products. More than half its business by value is still in fixed income, accounting for $102bn of the $176.5bn assets under management at the end of September 2005. The rest of the assets are divided between equity ($38.3bn) and real estate ($36.2bn) where it ranks as the fourth largest manager in the US.

"Real estate capabilities are strong but they tend to be very local and they don't necessarily transfer naturally to anywhere else in the world," says Lyster. "The one exception is real estate investment trusts (REITs), where we do have international capability, and we are currently in the process of building a European REITs capability here in London."

ver the past two years, Principal Global Investors Europe has been winning business in Europe across all asset classes, says Lyster. "This year we have won currency mandates from Dutch and UK pension funds, high yield mandates from Dutch and Danish investors, global equities from a UK multi manager, US equities from a Dutch bancassurer, and US real estate mandates from Scandinavian pension funds."

Principal is difficult to pin down as either an all-rounder or specialist manager, since it is a bit of both. "We are a multi asset class manager with a range of specialist capabilities, so we are more akin to the sort of multi-boutique model that has seen favour with some of the consultants recently. Even when we are offering core products the style we are offering them is a style that is quite specialist. What binds the capabilities together is that we are offering a range of products that are all value-added."

Principal has positioned itself as a multi-boutique manager through a series of acquisitions over the past six years, notably Spectrum Asset Management, Post Advisory Group and Columbus Circle Investors .

"I think we have been clever acquirers and developers of our own specialist capabilities," says Lyster. "We've let them keep their own name and culture and they are totally in control of the investment process. At the same time, we have provided support for their processes, whether this is back office support, compliance or any of the things that help them to become a significant asset manager."

Since their acquisition, Spectrum's assets have grown from $1bn to $13bn, Post Advisory's assets have grown from $3.5bn to $9bn, and Columbus Circle's assets have grown from $3bn to nearly $7bn. "It is unlikely that they would have been able to grow to that size without the backing of a large, well-resourced parent," he says.

The acquisition of Spectrum enabled Principal to launch Europe's first preferred securities fund in 2003. Hybrid preferred securities have been the highest yielding investment grade securities in the US capital markets. adds Lyster.
"Accessing these through a UCITs fund was attractive in markets such as Germany where investors were looking for high yield in a low yield environment."

The search for higher yields has transformed Principal from a core fixed income manager to high yield fixed income manager, says Lyster "We've been doing credit for over 40 years and we have an extensive range of investment grade capabilities in the US. Today, core fixed income is very difficult because spreads are so low and returns between managers are extremely tight. The only way to differentiate is in the skill-based areas.

"What has happened is that the markets have evolved from core to core-plus, where you add the high yield. We've gone a step further, into core-plus-plus, and now we're just focusing on the plus part."

One example of the core-plus-plus approach is Principal's strategic fixed income product, launched in Europe this summer.

"We have put into that product an array of high yielding fixed income asset classes which includes for instance preferred securities managed by Spectrum, high yield managed by Post Advisory, commercial mortgage-backed securities (CMBS), asset-backed securities, emerging market and debt Australian hybrids," says Lyster.

One attraction of this approach is the low or even negative correlations between asset classes. "For example, CMBS and high yield are negatively correlated because they tend to operate on different parts of the economic cycle."

Another attraction is that additional high yielding assets, such as leveraged loans, can be added to the mix. "We will look anywhere around the globe for the higher yielding parts of fixed income assets. When these are blended together, you get very interesting risk return dynamic."

Lyster emphasises that this is something more than a multi-asset strategy. "People might say that anybody can buy different bits of high yield and shove them all together. But we specifically design strategies that makes sense for this type of product.

"The high yield component, for example, is not just a basket of high yield bonds. It is a particular Yield To Call strategy that Post Advisory has developed.

Principal's strategic fixed income capability is designed to meet the demand for high total returns while managing downside risk. Its equities strategy is somewhat different, says Lyster: "What do pension funds want when they are investing in equities? They want consistent high performance, they want it to be repeatable, and they want it to be transparent so that they can understand what we are doing. So we designed our equity process around that.

"The basis for our investment philosophy was that superior stock selection, combined with risk controls, will produce consistent outperformance. Our research showed that stocks with three characteristics - improving and sustainable business fundamentals, rising investor expectations and an attractive valuation - outperform more often."

ranslating this insight into investment portfolios meant re-building Principal's equity platform. The aim was to combine a systematic/quantitative approach with a research analyst approach to stock selection, says Lyster. "We always felt that if you could combine the quantitative elements with the analyst, you would have a very strong process," says Lyster.

On the quant side of the equation, Principal has developed a global research platform which enables it to review and rank each week 10,000 stocks globally by sector, country and region, looking for the three characteristics of outperforming stocks. On the analyst side Principal has developed a system whereby it focuses analysts' attention on the stocks that the global research platform has identified as potential performers.

"We're telling analysts where to concentrate. For example, we only allow them to recommend buys from the top quintile of stocks ranked by our platform," says Lyster.

The results of this process speak for themselves, he says. "We manage all of our equity products, global, US and non-US, on the same global research platform. For most of them the tracking error ex-ante would tend to be in the 3-5% range and we've been able to deliver significant annualised returns over the past three years. US Select Equity, for example, has returned 6.5% excess return annually in what is meant to be a difficult asset class.

For Lyster, delivering consistently high returns, with no need to shoot the lights out, is what pension funds want and what Principal aims to provide.