The I Fund Struggles in 2018

The I Fund had solid returns in 2017 thanks to a weakening dollar, but so far in 2018 a strengthening dollar has been a major drag on international holdings.

As FEDweek’s TSP chart shows, the I Fund is this year’s worst performing TSP fund so far:

While American stocks have risen by 6.3-8.5% year-to-date, the I Fund has declined more than 4% for the same period. That’s a 10-12% performance differential over less than 9 months.

This makes the I Fund the weakest-performing TSP equity fund since January 2018, January 2017, January 2016, January 2015, and virtually every reporting period going all the way back to its inception in 2001.

The Dollar’s Strength in 2018

The dollar has strengthened in recent months compared to a basket of global currencies, as shown by the U.S. Dollar Index:

The dollar’s upward march in May coincided with the I Fund’s relative plunge around the same month. International companies usually report their earnings in their foreign currencies, and pay dividends in those foreign currencies, and it all translates into fewer dollars when the dollar is strong.

While there are many reasons for currency movements, the U.S. Federal Reserve’s tightening monetary policy is likely playing a major role in the dollar’s strength. While most central banks around the world are still doing quantitative easing (expanding their balance sheets) and keeping interest rates low, the Fed is now reducing its balance sheet (quantitative tightening) and gradually increasing interest rates.

As the following chart shows, while the Bank of Japan, European Central Bank, and Bank of England are still expanding their balance sheets at various rates or holding them steady, the U.S. Fed is reducing its own:

All else being equal, higher interest rates and tighter monetary policy makes the U.S. dollar a more desirable holding than many other currencies. An investor can hold dollars and safely get a mild return with interest, but if they hold other major currencies they won’t get any return at all. Therefore, more investors want to hold dollars, and this boosts the dollar’s value compared to other currencies.

Since this trend is expected to continue into 2019 and 2020, there’s a decent chance that the dollar will remain strong relative to many other currencies for a while. It’s no guarantee, however. Midterm results, global tariffs and trade, widening fiscal deficits, and other variables could affect the dollar’s value, because perceived stability of monetary and fiscal policy also plays a role in the strength of a currency.

Trouble in Turkey

Another issue that negatively impacted the I Fund in recent weeks is Turkey’s financial crisis. Several large banks in Italy, Spain, and France have mild exposure to Turkish assets, and Turkey’s currency has experienced a major decline.

For investors that have not kept up with the news, Turkey is currently experiencing a significant devaluation of its currency (the lira) compared to the U.S. dollar and other currencies. Turkey has been reliant on foreign investment for many years, and the government has kept interest rates lower than what many economists believe is prudent for that economy.

As a result, you could buy two lire for a dollar in January 2014, three lire for a dollar in January 2016, and about six lire for a dollar today. This is a major problem for Turkey because many Turkish corporations have debt in U.S. dollars. If their revenue is in lire, but their debts are in dollars, the relative size of their debt compared to their income can become unmanageable.

While Turkey’s government and households are quite solvent (low debt), their corporations are heavily indebted, and particularly in U.S. dollars. As the dollar has strengthened in 2018, it is putting pressure on international companies around the world that have debts in dollars, with Turkey being among the most-impacted. It’s also putting pressure on European banks that have exposure to Turkish assets.

Maintaining Diversification

Some investors have recommended holding outsized positions in the I Fund due to its perceived low valuations. This year’s performance so far shows the risks of concentrating too much in any one fund, especially the I Fund.

While the I Fund serves a useful role in the TSP, for most investors it’s best kept as a part of a diversified portfolio. For example, the 2020-2050 lifecycle funds have about 10-25% respective exposure to the I Fund, which is reasonable.

This makes it so that whether the dollar strengthens or declines in any given year, the combined portfolio can potentially still do well, and the lifecycle funds automatically rebalance into funds that are having a weak time. This quarter, for example, the lifecycle funds will buy the price dip in the I Fund to maintain their target allocations.

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.