My first article here on FEDweek, from back in December 2016, was about the structural problems of the I Fund. In that article, I discussed how the fund and the index it follows are heavily focused on a small number of slow-growth countries, which has led to underperformance in recent decades.
Read more: Think Twice Before Betting Big on the I Fund
The thesis of the article was that while putting some money into the I Fund makes sense for diversification (such as within a Lifecycle fund), investors might not want to overweight it due to the fund’s emphasis on slower-growth countries.
Since that article, the I Fund has returned 23.2% compared to 39.6% for the C Fund and 25.8% for the S Fund. The I Fund outperformed in 2017 due to a weakening dollar, but quickly fell behind in 2018 and 2019, resulting in significant underperformance over the past few years.
However, my stance on the I Fund is softening in 2019, because years of underperformance can lead to lower valuations and therefore create opportunity. In addition, the Federal Retirement Thrift Investment Board plans to expand the I Fund to track a broader index in 2020, which means it will become more diversified and have some access to faster-growing markets.
During each decade or so, one region in the world tends to become overvalued compared to others. In the late 1980’s, the Japanese stock market became one of the biggest market bubbles in history, and went on to underperform most other regions over the next decade.
In the late 1990’s, U.S. stocks reached nosebleed valuations, and went on to underperform most of its peers over the next decade. In the late 2000’s, emerging markets reached record valuations, and everyone was talking about the “BRIC” nations of Brazil, Russia, India, and China, and they went on to underperform over the next decade through today.
Usually these periods of overvaluation are a result of real economic outperformance. In other words, they do not happen randomly, but instead are based on true events that investors can rationalize.
Japan was doing great in the 1980’s, the United States was leading the tech boom in the 1990’s, and emerging markets were experiencing huge growth in the early 2000’s. However, investors tend to exaggerate and extrapolate recent history to a point where the winning region’s stock market becomes so expensive that it inevitably struggles to provide decent returns over the next decade compared to cheaper markets elsewhere that have a lower hurdle to step over.
Today, the areas of overvaluation are split. With negative interest rates, Europe and Japan have the most overvalued bond markets ever seen, but their stock markets are becoming rather cheap. In contrast, the U.S. stock market is once again one of the most expensive stock markets worldwide based on various valuation indicators. According to the normal price-to-earnings ratio, cyclically-adjusted price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, average dividend yield, and other factors, U.S. stocks are pricey.
As a simple example, this chart from Vanguard shows the growth and valuation differences between various regions:
The Vanguard S&P 500 ETF (which tracks the same index as the C Fund) has a price-to-earnings ratio of 20.4x, a price-to-book ratio of 3.1x, and 10.7% earnings growth. The Vanguard Developed Markets ETF (which tracks a very similar but non-identical index to the I Fund) has mildly lower earnings growth of 8.6%, but substantially lower valuations of 14.9x price-to-earnings and 1.5x price-to-book.
The Vanguard Emerging Markets ETF has the lowest valuations of the group, with a 13.2x price-to-earnings ratio and a 1.3x price-to-book ratio, but also the highest growth at 12.1%. When the I Fund is expanded in 2020, it will include these emerging markets for about 25% of its exposure, with the developed markets equal to the other 75%.
Valuation differences can’t tell us anything about what should happen over the next 1-2 years, so I don’t know which TSP funds will be the best in 2020 or 2021, for example.
Valuation differences tend to be strongly correlated with 5-10 year returns, however. So, while there is no guarantee that any region will underperform or outperform, it would certainly make sense to have some international exposure over the next decade for many investors, especially as the I Fund transitions towards being more diversified.
The Lifecycle Funds make diversification easy, and automatically re-balance themselves to avoid concentrating too much in any specific region or asset class.