Time to turn off the indexing autopilot in US large caps

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1 Principal Portfolio Insights Time to turn off the indexing autopilot in US large caps First quarter 2019 Key takeaways Set it and forget it is the default choice for indexing US large-cap equities, but this narrative is shifting Passive indexing has a long and storied history of disappointing investors when bubbles burst The dominant source of risk and return is in the 50 largest US stocks, not the 500 largest Factor-based investing and creative portfolio construction can seek to provide better outcomes High active share strategies, including lower-cost strategic beta solutions and active fundamental managers, are poised to return to favor in the late stages of the market cycle Author Mustafa Sagun Chief Investment Officer, Principal Global Equities The biggest consensus trade in modern history The legendary Jack Bogle revolutionized the investment management industry, most notably with respect to passive investing. One of Bogle s legacies was making such strategies broadly available to retirement plans, retail investors and institutions at low cost. However, based on Principal s investment philosophy and basic truths about long-term wealth creation, we strongly believe that investors should re-think their reliance on traditional capitalizationweighted indexes,1 particularly in US large caps, as we approach the later stages of a prolonged equity market and economic cycle. 500 stocks in the S&P 500 market-cap weighted index Top 50 Bottom 450 Highly efficient "Where the action is" Mega-cap strategy Factor-based and active fundamental A better option: outperformance and/or reduced risk To help mitigate risk, the key is to create lower-volatility exposure to the 50 largest stocks and apply the remaining opportunity set to factorbased exposures, thus seeking to mitigate downside risk and/or seeking to earn higher returns without excess market risk. Passively replicating the S&P 500 Index has become the consensus trade, evidenced by the trillions of dollars in index ETFs and mutual funds. Lower costs coupled with most fundamental managers underperformance have really made passive indexing a no-brainer for institutional and retail investors alike. Beta is enough is now a commonly accepted thesis to US large caps and seeking outperformance in other segments of global equities. Like most things in life, cheap and easy isn t always best. While we are not predicting a recession or a significant and prolonged equity market decline, the massive inflows into passive US large caps gives us pause. As with all trends driven by group-think and reduced risk awareness, the S&P 500 may eventually be in for a Minsky Moment if history is a guide. Coined after the economist Hyman Minsky, this is defined as a sudden and major collapse of asset values following a period of relative stability and risk-taking. 1A capitalization-weighted index is a market index with individual components that are weighted according to their total market capitalization. The larger components carry higher percentage weightings, while the smaller components in the index have lower weights. Principal Portfolio Insights 1

2 Behavioral economics tells us that investors experience gains and losses asymmetrically the discomfort of a dollar lost exceeds the joy of a dollar gained. The basic math of compounding also clearly illustrates this phenomenon. A 10% loss requires an 11% gain to break even. A 50% loss needs a 100% gain; a 90% loss, a 900% gain. In volatile markets, especially sharply falling ones, passive capitalization-weighted indexes tend to be painful reminders of the importance of seeking to mitigate downside risk and that simple beta is cheap for a reason! Overlooked risks of the S&P 500 Early advocates of smart/strategic beta argued that the S&P 500 and other capitalization-weighted indexes are structurally flawed. Principal s modern thinking redefines the market while challenging the assertion that capitalization-weighted indexes are good enough. By definition, a capitalization-weighted index assigns increasing weights to companies that have appreciated in price and decreasing weights to companies that have depreciated in price, an investment strategy akin to buying high and selling low. The upshot is that capitalization-weighted indexes expose clients to both the upside and downside periods of frothy valuations, as these indexes tend to chase bubbles up and get crushed on the way down, causing excessive and, in our view, unnecessary volatility. Pride comes before a fall Passive beta vulnerable to asset market bubbles 40% Tech/Communication Services % of S&P % Financial Services as % of S&P 500 Three pitfalls of passive 1. Prone to asset price bubbles as they chase what is going up the most 2. Biased to past success and popularity (momentum), irrespective of price (value) 3. Excessive risk concentration at market peaks 15% % of S&P % 30% 25% 20% 15% 12/1/97 3/1/98 6/1/98 9/1/98 12/1/98 3/1/99 6/1/99 9/1/99 12/1/99 3/1/00 % of S&P % 20% 18% 16% 14% 12% 14% 13% 12% 11% 10% 9% 8% 7% 10% 6% 6/1/00 9/1/00 12/1/00 3/1/01 6/1/01 9/1/01 12/1/01 3/1/02 6/1/02 9/1/02 6/1/04 9/1/04 12/1/04 3/1/05 6/1/05 9/1/05 12/1/05 3/1/06 6/1/06 9/1/06 12/1/06 3/1/07 6/1/07 9/1/07 12/1/07 3/1/08 6/1/08 9/1/08 12/1/08 3/1/09 3/1/14 6/1/14 9/1/14 12/1/14 3/1/15 6/1/15 9/1/15 12/1/15 3/1/16 6/1/16 9/1/16 12/1/16 % of S&P 500 3/1/17 6/1/17 9/1/17 12/1/17 3/1/18 6/1/18 9/1/18 12/1/18 Tech Bubble Tech/Communication Services % of S&P 500 Source: FactSet. Shown for illustrative purposes only. Global Financial Crisis Financial Services as % of S&P 500 Commodity Bubble Energy/Materials as % of S&P 500 Japan in the late 1980s is an extreme example of capitalization weighting gone wrong. Stocks on the Nikkei had risen so high that they comprised nearly half of the entire global market index, based on the expectation that Japan would continue to lead the world in technology. A decade later, after the bubble burst and the ensuing Japanese market decline, the index weight had shrunk to about 10% a disastrous outcome for passive global equity investors. More recent burst bubbles include the 1990s dot-com craze, the 2006 US housing crisis, and the 2017 shale oil collapse, all of which amplified passive investor losses. Principal Portfolio Insights 2

3 We believe this quote is particularly applicable to the massive pools of Success breeds complacency. assets that currently passively track the S&P 500. Convincing clients Complacency breeds failure. of the merits of active management isn t easy in the face of strong Andy Grove, Intel co-founder market performance. Let s face it: who cares about a percent or two of excess return when the market is already providing double digits? That calculus shifts markedly, however, when returns are single digit or negative in later market stages. We believe our strong conviction in rethinking passive S&P 500 replication is both timely and supported by our intensive efforts in researching and developing strategic beta and portfolio construction solutions for clients around the world. In our view, an optimal US large-cap strategy participates on the upside and seeks to protect on the downside, with reasonable fees and implementation costs, and no large, unintended concentrations of style risk. In our work with clients, we have analyzed the S&P 500 and its downside risks at length in evaluating low-cost strategic beta solutions for portfolio implementation. Our goal is to create options with a better risk-return trade-off than the S&P 500 in the form of higher returns and/or lower volatility. Deconstructing the S&P 500 Index Unbundling the components of investment returns We believe market cap weighted large cap index design is flawed given the top heaviness of the largest companies. Investors may be able to produce better outcomes by utilizing intelligent building blocks. Cumulative return 0% Top 50 companies equally weighted Bottom 450 companies equally weighted S&P 500 Index 3000% 2500% 2000% 1500% 1000% 500% 1/1/90 3/1/91 5/1/92 7/1/93-500% 9/1/94 11/1/95 1/1/97 3/1/98 5/1/99 7/1/00 9/1/01 11/1/02 1/1/04 3/1/05 5/1/06 7/1/07 9/1/08 11/1/09 1/1/11 3/1/12 5/1/13 7/1/14 9/1/15 11/1/16 1/1/18 Source: Principal Global Equities. S&P 500 index performance information reflects no deduction for fees, expenses, or taxes. Individuals cannot invest directly in an index. Shown for illustrative purposes only. Isn t the S&P 500 too efficient to bother with active management? Mega caps are the foundation for traditional capitalization-weighted large-cap indexes. For example, the top 50 stocks in the S&P 500 account for approximately 50% of its market capitalization. In our opinion, most investors should own these 50 stocks in somewhat similar proportion to their capitalization weight. As the most widely covered by analysts and other experts, they represent the most efficient part of the index where it is most difficult to uncover differentiated insights to add value fundamentally. From an outperformance standpoint, the remaining 450 companies and beyond has been where the action is. Principal Portfolio Insights 3

4 The same market efficiency argument applies to smart beta. No style or technical factors work consistently in this exclusive group of 50 companies. Indeed, the mega-cap universe accounts for roughly 85% of stock-specific risk in the entire S&P 500. Meaning, any factor tilt or stock picking in the bottom 450 stocks can be easily overwhelmed with a few wrong calls in the top 50 because this group s stock-specific attributes and risk profiles cannot be easily replicated. Apple s and Amazon s business models are relatively unique and mirroring their performance isn t as simple as owning other stocks with similar factor betas. Making big calls in this most efficient group, specifically being underweight in a few key stocks, explains much of the underperformance by large-cap fundamental managers over the last several years. Mega caps have been like an exclusive neighborhood they have been generally safer, less prone to decline during bouts of market and economic volatility, and more liquid because of their desirable characteristics. In our nearly two decades of applied factor research, we ve learned that no common equity factor (e.g., momentum, value, growth) is consistently successful with this group, with one notable exception: volatility. Lower volatility has provided a modest long-term return advantage over the S&P 500 mostly due to its focus on downside risk management. More so, it frees up investors overall risk budget for relatively inefficient asset classes and market segments where fundamental differentiation is more fruitful. In mega caps, less is more, namely less volatility, while maintaining broad exposure across this special group. Mega caps are like an exclusive neighborhood generally safer, less prone to decline during bouts of market and economic volatility, and more liquid because of their desirable characteristics. Performance and risk profile of mega caps Nasdaq US Mega Cap Select Leaders Index Performance profile Pre-inception performance 5/1/2001 5/31/2017 Risk profile 5/1/2001 5/31/2017 Annualized return 6.6% Standard deviation 12.8% S&P 500 annualized return 6.3% S&P 500 standard deviation 14.3% Annualized excess return vs. S&P % Beta 0.87 Up market capture 89% Sharpe ratio 0.41 Down market capture 86% S&P 500 Sharpe ratio 0.35 Source: Nasdaq and Bloomberg. Pre-inception performance of Nasdaq US Mega Cap Select Leaders Index TR versus actual performance of S&P 500 Index TR. Pre-inception performance and risk analysis for the period 5/1/2001 5/31/2017 (the last full month of data prior to inception). The Nasdaq US Mega Cap Select Leaders Index TR USD performance shown is the performance data published by the index provider, adjusted to reflect the fees of the ETF. The inception date of the index is 6/26/2017. This ETF is a new product, and any performance prior to the date of the index inception is hypothetical. All performance prior to this date represents pre-inception index performance data ( PIP ) and is reflected in the table above. Actual performance is reflected in the table in this presentation. Pre-inception index performance results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk that may affect the actual performance of the ETF(s). The actual performance of the ETF may vary significantly from the PIP data. PIP does not account for factors such as: transaction costs, liquidity, and other market factors. Had these factors been accounted for, actual performance would have been lower. Past performance is no guarantee of future results. Principal Portfolio Insights 4

5 Mega caps are compelling for investors focused on risk reduction For risk-averse investors, we believe it advantageous to isolate these special 50 stocks rather than the entire 500. Replacing a capitalization-weighted S&P 500 investment with a top 50 mega-cap strategy, has historically delivered a comparable return profile to the S&P 500 with notably reduced downside risk. For many investors, this alone may help improve long-term outcomes, understanding that this strategy will deviate from the S&P 500 in strong up markets but may catch up in down markets, seeking a better risk return trade-off over a market cycle. S&P 500 return vs percent contibuted by top 50 stocks Top 50 stocks consistently contribute more than 40% of the total S&P 500 return S&P 500 Return S&P 500 return 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% 12/31/ /31/1991 Percent contribution of top 50 stocks 12/31/ /31/ /30/ /29/ /31/ /31/ /31/ /31/ /29/ /31/ /31/ /31/ /31/ /30/ /29/ /31/ /31/ /31/ /31/ /30/ /31/ /31/2013 A barbell approach with mega caps and small caps 12/31/ /31/ /30/ /29/ /31/2018 Source: Principal Global Equities, Factset, S&P 500. S&P 500 index performance information reflects no deduction for fees, expenses, or taxes. Individuals cannot invest directly in an index. Shown for illustrative purposes only. Extending beyond the S&P 500, small caps may be an attractive solution for achieving a higher return profile. Taking a barbell approach that combines lower volatility mega-cap stocks with higher volatility small caps may be a compelling way to outperform with an equivalent level of risk as the S&P 500. While it is possible to use a passive index tracking strategy in this case, we believe it is suboptimal to do so, both in terms of returns and risk. Small-cap indexes include many fundamentally distressed companies that long-term investors should avoid. Instead, we recommend a systematic or active approach depending on client preferences. A multi-factor small-cap strategy can work well without increasing the total risk profile of the portfolio. It allows investors to tap into the long-term benefits of small caps and capture additional value through factor anomalies. As an example, a mix of the Nasdaq US Mega Cap Select Leaders Index and Nasdaq US Small Cap Select Leader Index has maximized returns with equivalent risk as the S&P % 150% 100% 50% 0% -50% -100% -150% -200% Percent contributed Principal Portfolio Insights 5

6 Managing risk budget Combining mega cap and small cap can potentially lower volatility profile Pre-inception performance S&P 500 Nasdaq US Mega Cap Select Leaders Index Nasdaq US Small Cap Select Leaders Index Efficient frontier Mega Cap Multi-Factor: 65%, Small Cap Multi-Factor: 35% 17% 16% 15% 14% Historical excess return 2.9% Same risk as the S&P 500 Return 13% 12% 11% 10% 9% 65% Mega Cap Multi-Factor, 35% Small Cap Multi-Factor mix could potentially lead to a higher expected return and similar standard deviation compared to the S&P 500. Modest increase in fees and costs Simple to implement (two strategies) Reasonable tracking error of 2.3% 8% 10% 11% 12% 13% 14% 15% 16% 17% 18% Standard deviation Source: Principal Global Equities. For illustrative and informational purposes only. Pre-inception performance of hypothetical portfolio versus actual performance of S&P 500 Index TR. Hypothetical portfolio is comprised of 65% Nasdaq US Mega Cap Select Leaders Index and 35% Nasdaq US Small Cap Select Leaders Index TR and includes pre-inception performance for the period 1/1/ /31/2015 (the last full month of data prior to inception). Assumes monthly rebalancing. The Nasdaq US Small Cap Select Leaders Index performance shown is the performance data published by the index provider, adjusted to reflect the fees of the ETF. The inception date of the index is 9/19/2016. The Nasdaq US Mega Cap Select Leaders Index TR USD performance shown is the performance data published by the index provider, adjusted to reflect the fees of the ETF. The inception date of the index is 6/26/2017. The ETF is a new product and any performance prior to the date of the index inception is hypothetical. All performance prior to this date represents pre-inception index performance data ( PIP ) and is reflected in the table above. Actual performance is reflected in the table in this presentation. Pre-inception index performance results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk that may affect the actual performance of the ETF(s). The actual performance of the ETF may vary significantly from the PIP data. PIP does not account for factors such as: transaction costs, liquidity, and other market factors. Had these factors been accounted for, actual performance would have been lower. Past performance is no guarantee of future results. Outperforming the S&P 500 with modern thinking and new tools We have demonstrated that simple building block approaches can offer an exceptional alternative to buying the S&P 500. We believe we are in the maturing stages of the US equity market, where seeking to provide downside risk management and adding value over market capitalization-weighted indexes will take on greater importance. Recall that market capitalization-weighted indexing has a long history of disappointing investors when bubbles burst, and markets turn south. The key is to create lower-volatility exposure to the 50 largest stocks and apply the remaining opportunity set to factorbased exposures, thus mitigating against downside risk and/or seeking to earn higher returns without excess market risk. Factor-based investing and creative portfolio construction can add value to US equities investing. We believe a compelling alternative to buying an S&P 500 strategy is pursuing a barbell approach by combining the Principal Small- Cap and Mega-Cap Multi-Factor strategies. Although our example focuses on lower-cost strategic beta solutions, active fundamental managers can also be used to diversify portfolios and may help boost returns. Principal Portfolio Insights 6

7 Performance and risk profile of small caps Nasdaq US Small Cap Select Leaders Index Performance profile Pre-inception performance 5/1/2003 8/31/2016 Risk profile 5/1/2003 8/31/2016 Annualized return 17.0% Standard deviation 17.4% Russell 2000 Index TR USD annualized return 10.3% Russell 2000 Index TR USD standard deviation 18.7% Annualized excess return vs Russell 2000 Index TR USD 6.7% Beta 0.91 Up-market capture 104% Sharpe ratio 0.91 Down-market capture 79% Source: Nasdaq and Bloomberg. Russell 2000 Index TR USD Sharpe ratio Pre-inception performance of Nasdaq US Small Cap Select Leaders Index TR versus actual performance of Russell 2000 Index TR. Pre-inception performance and risk analysis for the period 5/1/2003 8/31/2016 (the last full month of data prior to inception). The Nasdaq US Small Cap Select Leaders Index TR USD performance shown is the performance data published by the index provider, adjusted to reflect the fees of the ETF. The inception date of the index is 9/19/2016. The ETF is a new product and any performance prior to the date of the index inception is hypothetical. All performance prior to this date represents pre-inception index performance data ( PIP ) and is reflected in the table above. Actual performance is reflected in the table in this presentation. Pre-inception index performance results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance and cannot account for all financial risk that may affect the actual performance of the ETF(s). The actual performance of the ETF may vary significantly from the PIP data. PIP does not account for factors such as: transaction costs, liquidity, and other market factors. Had these factors been accounted for, actual performance would have been lower. Past performance is no guarantee of future results Principal U.S. Mega-Cap Multi-Factor Index ETF Performance History (as of December 31, 2018) Principal U.S. Small Cap Multi-Factor Index ETF Performance History (as of December 31, 2018) Total returns (%) Total returns (%) USMC inception 10/11/ month Year- to-date 1-year Since inception PSC inception 10/21/ month Year- to-date 1-year Since inception Net asset value (NAV) return Net asset value (NAV) return Market price return Market price return Nasdaq US Mega Cap Select Leaders Index TR USD Nasdaq US Small Cap Select Leaders Index S&P 500 Index TR USD Russell 2000 TR USD As of 12/31/2018 the net/gross expense ratio is 0.12%/0.15%1 As of 12/31/2018 the net/gross expense ratio is 0.38%. Source: Morningstar, State Street. Performance data quoted represents past performance. Past performance is no guarantee of future results and investment returns, and principal value of the Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted. Visit PrincipalETFs.com for current month-end performance. Total returns for periods longer than one year are average annual total returns. Total returns for periods longer than one year are average annual total returns. Total returns shown for periods of less than one year are not annualized. 1The investment adviser has contractually agreed to reduce total annual fund operating expenses for the Fund by waiving a portion of its management fee, or reimbursing the Fund, to the extent that total expenses exceed 0.12% (excluding interest expense, expenses related tofund investments, acquired fund fees and expenses, and other extraordinary expenses) expressed as a percent of average net assets on an annualized basis. It is expected that the expense limit will continue through the period ending 10/31/2019; however, Principal Exchange-Traded Funds and the investment adviser may mutually agree to terminate the expense limit prior to the end of the period. Want to learn more? Visit principaletfs.com.

8 Disclosures Definitions Beta: The measure of an investment's sensitivity to market movements Standard Deviation: A quantity calculated to indicate the extent of deviation for a group as a whole. Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of March Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. This material contains general information only and does not take account of any investor s investment objectives or financial situation and should not be construed as specific investment advice, recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account. Past performance is no guarantee of future results and should not be relied upon to make an investment decision. The strategies discussed are strictly for illustrative and educational purposes only there is no guarantee that any strategies discussed will be effective. Principal Global Investors and its directors or employees advise that they and persons associated with them may have an interest in the securities and/or financial products discussed herein and that they may receive brokerage, commissions, fees and other benefits and advantages, whether pecuniary or not and whether direct or indirect, in connection with such securities and/ or products. Information regarding the indexes presented in this material, including the calculation methodology used, is available upon request. The Principal U.S. Mega-Cap Multi-Factor Index ETF (USMC) seeks to track the Nasdaq U.S. Mega Cap Select Leaders Index, which provides exposure to the largest U.S. companies within the Nasdaq U.S. 500 Large Cap Index with a tilt to lower volatility companies. The Nasdaq US Mega Cap Select Leaders Index is designed to provide exposure to the largest US companies within the Nasdaq US 500 Large Cap Index with a tilt to lower volatility companies. S&P 500 Index includes 500 leading companies in industries of the U.S. economy. It was first published in Information regarding the comparison to the S&P 500 Index is available upon request. The Principal U.S. Small Cap Multi-Factor Index ETF (PSC) seeks to track the Nasdaq U.S. Small Cap Select Leaders Index, which is designed to provide exposure to companies within the Nasdaq U.S. Small Cap Index that exhibit high degrees of sustainable shareholder yield, pricing power, and strong momentum. The Nasdaq US Small Cap Select Leaders Index is designed to provide exposure to companies within the Nasdaq US Small Cap Index that exhibit high degrees of sustainable shareholder yield, pricing power, and strong momentum. Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. Information regarding the comparison to the Russell 2000 Index is available upon request. Carefully consider a fund s objectives, risks, charges, and expenses. For a prospectus, or summary prospectus if available, containing this and other information, visit principalfunds.com or call Sales Support at Please read it carefully before investing. RISKS Asset allocation and diversification do not ensure a profit or protect against a loss. Investing in ETFs involves risk, including possible loss of principal. ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply. Equity investments involve greater risk, including heightened volatility, than fixed-income. Small-cap stocks may have additional risks including greater price volatility. ALPS Distributors, Inc. is the distributor of the Principal ETFs. ALPS Distributors, Inc. and the Principal Funds are not affiliated Principal Financial Services, Inc. Principal, Principal and symbol design and Principal Financial Group are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company. Principal Global Investors leads global asset management at Principal. Principal Global Equities is a specialized investment boutique within Principal Global Investors. MM10445 I 03/2019 I PRI /2021