While 2017 was a very strong year for most TSP investors, many missed out on the impressive 37.2% gain in emerging markets because they simply didn’t have access through the TSP’s collection of funds.
The G Fund rose 2.3% in 2017, while the F Fund rose over 3.8%. The S Fund went up by 18.2%, the C Fund rose by 21.8%, and the I Fund topped the list at 25.4% returns – and all of this is good. However, despite its rather strong performance this year, the I Fund lagged many other broad international index funds in 2017, like the Vanguard Total International Stock fund, because it was overly-concentrated in Japan and Europe and lacked emerging markets exposure entirely.
Although I’m bullish for the long-term on most international markets at current valuations, I do not consider the I Fund to be the best-positioned fund to capture the growth potential, since it’s so concentrated in Japan.
It’s good to have exposure to the I Fund (and I’m a big advocate for the Lifecycle funds that include I Fund exposure), but if you have other investment accounts it pays to use them to balance out some of the I Fund’s shortcomings.
The Importance of Emerging Markets Exposure
The collection of emerging markets is defined to include about two dozen countries that are becoming increasingly developed with functioning capital markets, including China, India, Brazil, South Africa, Taiwan, South Korea, and others. As a whole, they contain a very large chunk of the world’s population and their economies for the most part are growing more quickly than developed markets.
During the five-year period between 2002 and 2007, emerging markets gave investors a huge 500% total return. A big portion of these gains were briefly lost and quickly recovered during the global financial crisis of 2008, but then emerging markets entered into a nearly decade-long period of flat returns, as shown by the chart below:
These huge up and down swings in performance for emerging markets were mostly due to changes in valuation, and this is why I focus so heavily on valuation when performing market analysis. Stock performance is based not just on how well companies do financially; it’s also based on how cheap or expensive their stock prices are relative to their fundamentals when you buy and sell them.
For example, here is a chart showing the market capitalization as a percentage of GDP for China, India, and Brazil over the past couple decades. It compares the total price of all their stocks to their actual national economic size:
In the beginning, these markets were cheap relative to their economic size, with their market capitalizations being about 50% or less relative to their GDP. In 2006 and 2007, valuations in these countries shot upward very quickly to 100-150% or more of their GDP, because investors were excitedly paying more and more money for companies that had not changed very much in such a short period of time. And then, over the past decade, we’ve seen a cooling-off of valuations in their respective emerging markets.
These countries’ economies continued to grow over the past ten years, and their companies continued to increase in profitability for the most part, but the reduction in average valuations offset these gains, resulting in the relatively flat performance shown by the previous chart.
Going into 2018, it’s unlikely we’ll see a year quite as strong as 2017 for emerging markets. We could even see a down year if certain conditions play out. However, their valuations indicate that total emerging market performance should be considerably better over the next decade than it has been over the last decade.
The decade of 2007-2017 began with exceedingly high valuations in emerging markets and ended with reasonable valuations, which offset much of the actual economic growth. The decade of 2017-2027 is beginning with reasonable valuations, which gives investors a much stronger probability of doing well over the decade if they have exposure, even if certain years could of course be difficult.
The TSP I Fund lacks exposure to emerging markets, because it follows the MSCI EAFE index rather than a broader international index. But investors that have IRAs or other investment accounts to supplement their TSP can buy emerging markets funds to ensure that their overall asset base has this broad exposure and diversification even if their TSP account does not.
As always – If in doubt, talk to a financial professional about what funds or what levels of exposure or overall asset allocation are right for you and your unique situation.