The I Fund is back in the news, for another round of controversy due to a decision to switch to a broader investment index that includes exposure to Chinese companies.
The White House is seeking to block the switch, which is now underway and is on track to finish by the end of this year unless it is blocked.
What the Switch Means
The Thrift Savings Plan (TSP) has five core funds, including the C Fund for large cap stocks in the United States, the S Fund for small cap stocks in the United States, the I Fund for stocks in other countries, the F Fund to follow a broad mix of bonds in the United States, and the G Fund to invest in a unique set of U.S. Treasury securities. And then there are the L Funds (lifecycle funds) that combine those five funds into various target date retirement accounts.
The I Fund has followed the MSCI Europe, Australasia and Far East Index (MSCI EAFE) since the I Fund’s inception in 2001. The index, provided by Morgan Stanley Capital International (MSCI), has been around since 1969 and represents a large basket of developed country stock markets, with Japan and the United Kingdom representing the two biggest components at present.
It has a rather narrow selection of international markets:
And the top five countries account for over 71% of the index, with the top two countries alone accounting for over 41% of it:
Back in 2017, the Federal Retirement Thrift Investment Board made the decision to switch the Index that the I Fund follows to the MSCI All-Country Ex-US Investable Market Index (MSCI ex-US ACWI IMI), which invests in both developed and emerging markets, with about 3/4ths weighting towards developed markets based on market capitalization.
This index has more geographical diversification than the current one:
And the top 5 countries only represent less than 52% of the index:
Although the TSP is very large, the I Fund is one of the smallest funds with $54 billion in assets as of year-end 2019. This switch would put approximately 10% of it, or about $5-6 billion, into Chinese stocks.
The 2040 lifecycle fund, representing a diversified TSP allocation, has about 25% invested in the I Fund, and if 10% of that fund is invested in China, it would mean about 2.5% of the total account is invested in China.
Reasons for the Switch
The FRTIB acts as fiduciaries, so their responsibility is to do what they think is correct for the risk-adjusted retirement returns within the TSP.
Most large retirement funds, including Vanguard and the other top 5 largest providers of target date funds, have a broad international equity exposure which includes an index equal to or similar to the MSCI All-Country Ex-US Investable Market Index, rather than the more narrow EAFE Index.
The TSP is an outlier among virtually all large retirement plans for having no emerging markets exposure, and emerging markets now represent over half of the world’s GDP on a PPP-calculated basis, or a smaller but still very large chunk of world GDP on a nominal-calculated basis. They have been growing faster than international developed markets such as Japan and Europe.
The FRTIB had outside investment consultants recommend the switch back in 2017, and after review, the FRTIB decided to go forward with the switch.
Complicating matters is the fact that the current FRTIB leadership was appointed under the Obama administration. Their terms have run out, but because President Trump has not put forth any nominees, they have remained in their positions by default. Outside of this recent issue regarding the I Fund, the FRTIB is generally not in the political spotlight so it wouldn’t normally be a high-priority position to switch out.
Arguments Against the Switch
The United States and China have engaged in a trade war for a number of years, and the recent outbreak of COVID-19 from China has further increased tensions as it has spread across the world. More broadly, the two countries represent sizable economic and military powers that have a significant number of disputes and differences, including intellectual property theft by China, disputes over the South China Sea, human rights issues, and more.
Some members of Congress and the Trump administration do not want the TSP to invest in Chinese companies. For example, some point out the irony of U.S. soldier retirement plans putting funds into Chinese firms, which represent a potential adversary to them.
On the other hand, China is heavily invested in the United States; they own over $1 trillion in U.S. Treasury securities as well as a significant amount of U.S. real estate and stocks, so they ironically do help fund the U.S. military in an orders-of-magnitude larger way than Americans fund China’s military.
This whole situation is quickly becoming one of the interesting ramifications of globalization and passive index investing. As the world has globalized its supply chains and turned towards broadly diversified index funds, capital has been invested everywhere.
Apple and other U.S. companies put significant supply chains in China, China used a lot of the dollars they earned from trade to buy U.S. Treasuries and U.S. property (in other words, reinvested in the United States), and as China grew its economy as a percentage of the world economy, Americans began investing a larger sliver of their retirement portfolios into Chinese stocks, especially if they follow a passive methodology weighted by market capitalization.
But if two major players in that system seek to reverse globalization and distance themselves, and perhaps put capital controls in place, it creates complications for supply chains, index funds, and other intertwined systems, with the I Fund being front and center in that issue.
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Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.