Lyn Alden

Japan’s population is in decline, and that’s a problem for the under-performing I Fund. Fully 25 percent of the fund is invested in Japan, and while the I Fund presents an opportunity for TSP investors to diversify away from the US, it’s a good idea to think twice before over-allocating in one of the worst performing TSP index funds.

Since the I Fund’s inception in 2001, it has lagged behind the other four TSP index funds, as shown by the chart below. Annual returns have averaged 4.23% over the past 16 years, and when adjusted for inflation, this amounts to only about 2-3% real returns per year, despite having just as much equity risk as the C Fund or the S Fund.


This article takes a closer look at the I Fund to help readers understand what it contains and why it has been performing this poorly, and what the future may hold.

The I Fund follows the MSCI EAFE index, which stands for the Morgan Stanley Capital International Europe Australasia and Far East index.

What this means is that unlike some of the broadest international funds like the Vanguard Total International Stock index, the I Fund excludes equities from all emerging markets and from Canada. It only holds funds in developed countries in Europe, Australia, and Asia, and is heavily concentrated in just five of them: Japan, the UK, France, Germany and Switzerland.

A full quarter of the fund is in Japan, and about 70% of the fund is held in just five countries, because this is a market-capitalization weighted index which puts assets into countries strictly based on the size of their market. Not many people realize that the I-Fund is this geographically concentrated.

Here’s a closer look at the MSCI EAFE’s historical returns. This index was created in 1986 and has been back-tested by MSCI to 1970, so here is a table of both the longer-term and shorter-term annual returns.


Returns over the past quarter century have been poor, while returns prior to that were seemingly decent. Because the I Fund was created 16 years ago, its entire existence has been in the poor-performing period of the MSCI EAFE index thus far.

There were four primary reasons for this deterioration of MSCI EAFE performance:

1) Japan had an asset bubble in the late 1980’s that was twice the magnitude of the late 1990’s US Dotcom bubble, which artificially improved Japanese returns in the 1980’s and then negatively impacted them in the 1990’s and thereafter.

2) Japan’s population growth rate was decent at around 1% per year for the 1960-1980 period. But since 1980, the population growth has steadily deteriorated to one of the lowest growth rates in the world, and crossed into negative territory in 2010. The population of Japan is now officially shrinking, which puts major downward pressure on its ability to grow economically. Its GDP has been essentially flat since 1995.

3) Major inflation in the 1970’s and 1980’s drove the returns up for that earlier period in the 1970’s and 1980’s. The 8.79% annual returns since 1970 may seem reasonable, but the inflation-adjusted returns were only 4.47% per year.

4) The UK, France, and Switzerland all had poor stock performance over the past two decades, partially because their markets were overvalued in 2000 and partially because they have slower population growth than the United States.

Therefore, the index’s returns have been rather low for nearly a half century, but only in the last quarter century have the returns become quite awful.
Because Japan accounts for a full quarter of the I Fund, their fates are inevitably tied together. Looking forward into 2017 and beyond, Japan continues to have a shrinking population, an aging demographic, and has the single highest national debt-to-GDP ratio in the world at 230%. Higher than Greece.

Here’s the historical performance of the Nikkei 225 index, which serves as Japan’s primary stock index:

*Graph by Yahoo Finance

In a truly remarkable period of poor returns, Japan’s stock market is far lower now than it was 30 years ago. It has defied the notion that the stock market must go up over time, and has dragged down the MSCI EAFE for three decades, and the I-Fund since inception. The severity of their 1980’s asset bubble, followed by the stagnation of their flat and now shrinking population is apparent on the chart.


Considering Japan’s shrinking population and high debt, there’s little reason to expect the next quarter century to be any different than it has been recently. Their GDP has been totally flat since 1995, with little reason to expect anything other than very slow growth going forward.

There is reason, however, to be bullish on the long-term prospects of the United Kingdom, which makes up 18% of the I Fund. Although the country faces issues related to its potential exit from the European Union, the market valuation of the FTSE 100 index (the primary UK stock index) is historically low, when measured in terms of the cyclically-adjusted price-to-earnings ratio. Their population growth rate is slow but positive, at about 0.6% per year. They have no current asset bubbles, they control their own currency, and so there are no hard obstacles that would prevent them from achieving reasonable 6-10% returns over the coming decade or two, barring any major disasters.

The good news overall for the I-Fund is that the UK is poised for reasonable returns, and neither the Japanese, French, German, or Swiss markets are highly overvalued when measured by the cyclically-adjusted price-to-earnings ratio or related metrics. Overall I Fund returns over the next quarter century are likely to be modestly better than the preceding quarter century, which was dragged down by bubbles in all the major economies.

The bad news is that Japan has structurally deteriorated from a growth perspective, with no signs for improvement. If their population growth reverses their four-decade downward trend and begins rising again, there may be reason to be hopeful. But unless that becomes the case, Japan lacks a clear means of growth for the foreseeable future.

For TSP investors, it’s advisable to diversify away from the US and hold some assets in the I Fund. However, it would not be prudent to overweight the I Fund by putting a large percentage of assets there in the hopes of superior foreign returns.

For investors that hold funds outside of the TSP, you may want to consider increasing exposure to emerging markets or Canada indices to offset the lack of exposure that the I Fund has in those regions.

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.