Aside from the G Fund that invests in special treasuries, the TSP uses index funds for its other funds, meaning it follows passive benchmarks to own a broad number of stocks.
The C Fund follows the famous large-cap U.S. S&P 500 index. The S Fund tracks an index that invests in U.S. small and medium-sized companies. The F Fund follows the Bloomberg Barclays U.S. Aggregate Bond Index. The I Fund follows the MSCI EAFE international stock index. These are the only five funds in the TSP.
Since inception in 2001, the I Fund is the only international stock fund in the TSP, and it follows the MSCI EAFE index which stands for the Morgan Stanley Capital International Europe, Australasia, and Far East index. It invests only in developed markets in those regions.
The Federal Retirement Thrift Investment Board (FRTIB), which oversees the Thrift Savings Plan, decided in 2017 after a comprehensive review to expand the number of countries that the I Fund invests in, meaning they will switch to a broader index that includes Canada and various emerging markets that the current I Fund index has no exposure to.
Most retirement plans these days, ranging from Vanguard to Fidelity to other providers, include a portion of emerging markets in their overall plan. The I Fund was originally meant to transition to the broader index in 2019, but was delayed to start in 2020.
Specifically, the I Fund is intended to be switched from the MSCI EAFE index to the MSCI All-Country Ex-USA Investable Market Index (MSCI ACWI ex-USA IMI), which is one of the broadest indices for world markets. It would greatly expand the I Fund’s geographic exposure:
However, because the indices are weighted by market capitalization, and Europe and Japan represent the bulk of the world’s market capitalization outside of the United States, the change for the fund is only moderately impactful. Less than one-quarter of the fund, based on the indices as currently balanced, would be invested in emerging markets. The other three-quarters would remain in developed markets. Since the inception of the MSCI emerging markets index in the 1980’s, the emerging market index has outperformed the MSCI EAFE index, but with more volatility, so it has historically been good to balance it with developed markets in a globally diversified portfolio.
Senator Marco Rubio has announced plans to introduce legislation that, if passed, would block the I Fund from changing its index, with the desired goal to stop the I Fund from investing in Chinese stocks in particular. The new I Fund index as currently planned would put less than 10% of its assets into Chinese stocks, based on market capitalization at the current time.
The L2050 lifecycle fund, since it puts a bit under 30% into the I Fund, would put a bit under 3% into Chinese equities, if the broader index is applied. This provides a high-level example for how much the typical TSP account might put into Chinese stocks if the I Fund switches to the broader index.
The United States and China are currently involved in a multi-year trade war that ranges from intellectual property rights to trade imbalances to accounting standards, and for some politicians this extends to human rights as well. Details aside, it’s not a particularly partisan issue from a high-level view; several members of the Republican party and Democratic party currently have adopted hardline approaches towards China as this process plays out.
This news adds complexity to the otherwise boring system of passive index investing. When financial experts decide to include more countries purely for risk-adjusted return optimization and therefore decide to invest in broader global index funds, but politicians decide to block investment in specific individual countries for political reasons, civilian federal employees and military personnel can be caught in the middle.
To put the numbers in context, the TSP has over $500 billion in assets under management, but the I Fund only holds about $50 billion in assets. The new index, if transitioned to, would put less than 10% of the I Fund into China based on market capitalization, representing about $5 billion.
China’s stock market capitalization is worth about $7 trillion, or about 1,400 times as much money as the I Fund would invest into China if the broad index is applied. And China holds over $1 trillion in U.S. federal debt securities. Americans hold hundreds of billions of dollars in Chinese markets. The I Fund’s potential $5 billion allocation to China would be a statistical rounding error, a fraction of 1% of these numbers. Instead, right or wrong, a law like this would be largely a symbolic gesture rather than one that meaningfully impacts China’s balance of payments or equity markets.
It’s unclear at the current time how this will play out. While this potential legislation would not have any meaningful impact on the United States or China at the sovereign level due to the I Fund’s numerical insignificance, whether or not civilian federal or military personnel have any access to emerging markets over the coming years and decades could potentially meaningfully impact their rates of return. There are some other options the TSP board can consider, such as indices that include emerging markets but not China, but how this will resolve is currently unknown.