This year has seen a significant divergence between the international I Fund and the two American stock funds, the S Fund and C Fund. So far in 2018, the C Fund is up over 6% and the S Fund is up almost 10%, but the I Fund is down about 3%.
Some investors may see this as a sign to sell the I Fund and buy the S Fund and C Fund, but that would be chasing past performance rather than planning for potential future performance. On the other hand, value investors that like to invest in cheap things may see this as an opportunity to invest more heavily in the I Fund.
The lifecycle funds naturally follow the value method, which is good. Since they have target allocation percentages, if one fund goes down in price while another goes up in price, it means the fund must sell a bit of the higher-performing fund and buy more of the lower-performing fund to rebalance. Since the I Fund is lower recently, the lifecycle funds have been selling some of the currently stronger funds to buy a bit more into the I Fund.
Let’s look a bit into the numbers. Just because a stock market goes down recently doesn’t mean it’s cheap, and just because a stock market goes up doesn’t mean its expensive. It all depends on what the price is relative to the fundamentals of the market – the price-to-earnings ratio, price-to-book ratio, growth rates, and balance sheets of the underlying companies.
Here’s a combined chart of some Vanguard index funds, similar to the TSP funds, that can show us some insights into markets around the world:
The “Total Stock Market ETF” is Vanguard’s closest approximation to the combined C and S Funds in the TSP, since it includes both large and small/mid-cap American companies. As you can see, companies in this fund on average have high price-to-earnings ratios of over 20 and high price-to-book ratios of over 3. On average, companies in the fund have earnings growth rates of 8.4% per year over the past five years.
The “FTSE Developed Markets ETF” is similar to the I Fund, except that it also includes Canada and South Korea, and is thus a bit more diverse. As you can see, it currently has average earnings growth that is almost as high (8.2%) as American stocks, but the average price-to-earnings ratio is relatively low at just over 14, and the price-to-book ratio is 1.6. Not bad!
The “FTSE Emerging Markets ETF” focuses on companies in developing countries, and the I Fund has no exposure to them until approximately 2019 when the TSP plans to change the I Fund to a broader index. This fund has the highest 5-year earnings growth rate at 13.7%, but has low price-to-earnings of about 14 and low price-to-book of about 1.8. In other words, it’s both cheap and has high growth, and is thus likely the overall best value over the long term. On the other hand, emerging markets have higher volatility – they’ve done even worse than the I Fund this year and an investor has to be able to stomach that kind of volatility during good and bad years alike if they want to have emerging markets exposure.
Peter Lynch, one of the best-performing mutual fund managers in history who ran the Magellan Fund at Fidelity, once popularized what is known as the “PEG” ratio, which is the price-to-earnings ratio divided by growth. Usually high-growth stocks have high price-to-earnings ratios, while low-growth stocks have lower price-to-earnings ratios, but not always. The lower the PEG ratio that a stock has, usually the better value it is because you’re getting a lot of growth for a reasonable price-to-earnings ratio. On average, Vanguard’s data shows that American stocks currently have a PEG ratio of 2.45, which is high. For international developed markets, the PEG ratio is more reasonable at 1.72. And for emerging markets, it’s 1.03, which is great.
Value Historically Pays Well
Research by Mebane Faber, the CFO of Cambria Investment Management, calculated that if you had invested in the bottom 25% of global stock markets based on their cyclically-adjusted price-to-earnings ratio from 1993 to 2015, you would have three times as much money by the end compared to simply investing in the S&P 500 (which the C Fund tracks):
The thing is, most investors wouldn’t do anything like that, because it would be scary. Investing in the cheapest markets around the world usually means investing in the countries with the most bad news at the moment, which makes for a wild ride. Investing with a long-term view when there is a lot of short-term bad news historically pays off well.
Overall, companies in the I Fund deserve lower valuations because their countries have lower GDP and population growth rates, most of the top countries have very high sovereign debt levels (Japan, France, Italy, Spain, etc), and there is very little exposure to technology stocks in European markets. However, such a significant difference in valuation is likely unwarranted.
More on TSP investment fund choices at ask.FEDweek.com
The I Fund deserves a spot in a diversified TSP portfolio, but betting too much on it can be risky, due to the lower-growth and higher-debt nature of the countries involved. The lifecycle funds strike a good balance in my opinion, with 10-25% of their capital invested in the I Fund, and they frequently rebalance to buy dips like this. Starting in 2019, the I Fund is planned to include emerging markets, which will diversify its geography and likely improve its overall long-term growth prospects.