TSP

The I Fund will soon include exposure to emerging markets, which could be poised to outperform US stocks in the coming decade

Lyn Alden

The I Fund has been the worst-performing equity fund in the TSP since its inception in 2001. Going back further, the MSCI EAFE index that the I Fund tracks has underperformed U.S. stocks for almost 50 years since its inception in 1970, while also having higher volatility.

However, the international index did outperform in certain decades over that long five-decade timeline, even though it did underperform overall.

I originally wrote about the problems with the I Fund in my first FEDweek article back in December of 2016: Think Twice Before Betting Big on the I Fund.

Over the 2+ years since then, the I Fund has continued to lag the C Fund and S Fund despite having a strong 2017. Specifically, the I Fund is up about 19.3% since late-December 2016 while the C Fund is up 29.5% and the S Fund is up 25.9%.

The thesis of that 2016 article was that while some allocation to the I Fund provides useful diversification for a TSP portfolio, its weight into various countries based on market capitalization as well as its total exclusion of emerging markets means that it is highly concentrated into certain slow-growth countries like Japan, which has negative population growth and the highest sovereign debt-to-GDP ratio of any country in the world.

In the time since that article was written, the TSP announced plans to switch the I Fund’s index to one that includes emerging markets and Canadian equities, rather than continuing to follow the EAFE index which mainly focuses on Europe and Japan. This will broaden the I Fund’s geographic exposure and give it more access to global population growth. Originally this switch was expected to happen in 2019, but according to their December 2018 meeting minutes, they now plan to wait until they bid the contract to a new manager, and expect the transition to happen in 2020.

U.S. stocks continued to get more expensive over the past couple years, while foreign stocks lagged. In particular, emerging markets currently offer higher earnings growth and lower valuations than U.S. equities, while developed/EAFE countries offer slower growth but lower valuations as well.

See Also: An Update on Stock Valuations

After a long time of I Fund under-performance, are we gearing up for one of those decades where international indices outperform U.S. stocks? Some analysts think so.

Research Affiliates is a firm that advises on about $200 billion in assets for other companies, and publishes monthly updates on expected 10-year returns for various asset classes. This is their latest estimate for annual equity returns over the next decade:

Chart Source: Research Affiliates

They expect emerging markets to provide over 9% annual returns over the next decade, followed by about 7.8% returns for the EAFE index. Trailing these expected returns are U.S. stocks which they expect to produce 3-4% returns.

Until we look back a decade from now, it’ll be impossible to truly know what these returns will be. This assessment by Research Affiliates is mainly based on current valuations, current dividend yields, and expected growth. After such a long bull run in U.S. stocks and rather high valuations, they expect some mean reversion to occur and for international stocks to outperform, led by emerging markets.

In addition, the U.S. dollar is currently very strong compared to its historical relationship with other currencies, and if its exchange rate weakens, that would be a tailwind for assets denominated in other currencies.

It’s certainly possible that international stocks will do well for investors that can handle that extra volatility, after this long stretch of international underperformance resulting in a wide valuation discount compared to U.S. stocks. The lifecycle funds mitigate the extra volatility from the I Fund by continually rebalancing into all five funds.

I currently invest more heavily in emerging markets than developed markets for my international holdings. While this option is not available in the TSP, the I Fund is expected to begin including emerging markets in 2020. Based on current weightings, 20-25% of the new I Fund will be in emerging markets while the remaining 75-80% will be in developed markets.

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.