The I Fund has underperformed the C Fund over the past year, past three years, past five years, past ten years, and since inception. But could this eventually change, with the I Fund leading the charge to higher levels?
Based on history, it’s a possibility.
Since the inception of the MSCI EAFE index in 1970 (tracking large company stocks in developed markets outside the US and Canada – a sort of international version of the S&P 500), it has underperformed the S&P 500. However, there were multiple decade-long periods where it outperformed. The I Fund has tracked the MSCI EAFE index since the inception of the I Fund in 2001.
The past two decades show that results can be very different on a decade-by-decade basis:
Since 2002, the S&P 500 has increased by 158%, or 238% with dividends reinvested. Meanwhile, the MSCI EAFE index has only grown by about 65%, or 132% with dividends reinvested.
In the prior decade, U.S. stocks started out very highly-valued during the Dotcom Bubble, and foreign stocks were able to significantly outperform for quite a while.
However, the U.S. stock market caught up. During this past decade, the United States stock market has significantly outperformed most foreign stock indices including EAFE, largely thanks to the rise of the big tech stocks like Apple, Amazon, Alphabet, Microsoft, and Facebook.
This chart from Star Capital shows how the best-performers during this past decade were almost a mirror-image flip from the worst performers in the decade before:
Currently, EAFE index stocks are a lot cheaper than the S&P 500 index stocks.
S&P 500 stocks have an average price-to-earnings ratio of over 20x and a price-to-book ratio of over 3.2x. Meanwhile, EAFE stocks have an average price-to-earnings ratio of under 15x and a price-to-book ratio of under 1.6x. Emerging market stocks, which are expected to be added to the I Fund in 2020, currently have an average price-to-earnings ratio of less than 12x and a price-to-book ratio of about 1.5x.
Some sectors tend to trade for cheaper valuations regardless of their location. For example, banks and oil producers typically trade at cheaper multiples than software companies. If we normalize for sector differences because EAFE has far less technology, the valuation gap narrows but doesn’t close completely; EAFE stocks are still a bit cheaper on a sector-by-sector basis than stocks in the S&P 500.
Emerging markets are particularly interesting because they have just as much exposure to technology stocks as the S&P 500, and have faster earnings and GDP growth in general, but still trade at a massive discount to U.S. stocks due to higher volatility, increased currency risk, and more exposure to the ongoing trade war.
Countries represented within the I Fund have substantial risks.
Japan and Europe have lower economic growth than the United States, mainly due to lower population growth (or outright negative population growth in the case of Japan). Their central banks, including the Bank of Japan and European Central Bank, have been more aggressive with lower interest rates and stimulation via quantitative easing than the U.S. Federal Reserve, leading to a lot of weakness in their banking sectors. Europe faces an extra layer of political risk due to uncertainties around the stability of the European Union.
The Lifecycle funds give TSP investors balanced access to U.S. stocks and foreign stocks, and are a great fit for most investors. They maintain pre-set allocations, so if U.S. stocks outperform during a year and the valuation gap widens, the lifecycle funds will sell some U.S. stocks and buy some foreign stocks. Likewise, if U.S. stocks have a big dip and underperform, narrowing the valuation gap, the lifecycle funds will re-balance and add more capital into them.