Federal News Radio reported in June that the TSP board is researching the possibility of broadening the I fund to include more countries and a broader range of market capitalizations.

Consulting firm Aon Hewitt recommended to the TSP Board that the I fund should be reconstructed to include Canada, emerging markets and small-cap companies.

Currently, the I fund is based on the MSCI EAFE (Europe, Australasia, and the Far East) Index, which invests in developed countries around the world, but excludes Canada, and excludes all emerging markets.

Back in December, I wrote an article expressing my view that the MSCI EAFE index is not the ideal index for the I fund to follow, because it results in heavy concentration into the slow-growth countries of Japan, the U.K., France and Switzerland, which has made it the lowest-performing fund of the TSP since its inception. The vast majority of the fund’s assets are invested in Japan and Europe.

Here’s a map showing how undiversified the “international” fund is:

Source: Blackrock

My opinion is that a broader approach would be safer and would likely result in better long-term returns, especially if it’s the only international option available for TSP investors.

I was glad to see Aon Hewitt’s recommendation to broaden the I fund, and the TSP Board’s willingness to further investigate the issue. The I fund has had a great year, but it continues to be limited compared to other international funds.

The price-to-earnings ratio of the American stock market is quite high right now compared to its historical average, which is a negative indicator for good returns over the next 10-to-20-year period.

It’s important to have a diverse portfolio that includes exposure to markets around the world, including ones that have less expensive valuations.

This article outlines what other indices the I fund could likely track if it were to be reconstructed at some point, what the main differences would be and what it could mean for your TSP holdings.

MSCI vs FTSE: What are the differences?

Most large international indices are based on either the Morgan Stanley Capital International (MSCI) indices, or Financial Times Stock Exchange (FTSE) indices.

Blackrock, the largest asset manager in the world, tends to reference MSCI for their international funds while Vanguard, the second largest asset manager in the world, more heavily references FTSE indices for theirs.

Although the MSCI and FTSE indices are very similar, they’re not identical. One of the biggest differences right now is that MSCI considers South Korea to be an emerging market, while FTSE has considered it to be a developed market since 2009. Therefore, the I fund doesn’t have South Korean exposure either.

These are currently among the most widely-followed international stock indices:

Because the TSP contracts the management of all its funds, except the G fund, to Blackrock, Inc., it’s likely that any potential reconstruction of the I fund would still follow an MSCI index.

Comparing historical rates of return

Narrowing down the list of candidates for the I fund to MSCI indices only, we can compare their historical rates of return between May 1994 and June 2017:

Source: MSCI 6/30/2017 fact sheets

The MSCI EAFE index had the worst returns over this 23-year period, partially because it was the most heavily concentrated in Japan, which has a shrinking population. Nearly a quarter of the index is in Japan, while another 18 percent is in the U.K.

Having a slightly broader list of countries to include Canada made for an improvement in returns for the developed-market “world” funds over nearly 2 1/2 decades compared to “EAFE” returns, while also keeping overall risks lower in my opinion.

Canada continues to have a growing population and has a different set of geopolitical risks than Europe, which historically has helped improve returns and diversify risk for those world funds.

Broadening the list of countries to include emerging markets in the “ACWI” funds gave another slight boost to long-term historical returns, and diversified the risk even further to include countries in South America, additional countries in Asia, and a small dip into Africa.

It’s important to note that “emerging markets” still only includes robust economies, like Brazil, Taiwan and South Korea, while the truly undeveloped economies of the world are classified as “frontier markets” and are not included.

Lastly, the historical results show that including small capitalization companies in the “investable market” versions of those funds didn’t make a big difference, and actually reduced returns slightly compared to the standard large-cap and mid-cap “world” and “ACWI” funds. On top of that, all else being equal, it’s more expensive for an index fund to include a larger number of companies, meaning that the funds that include the small caps, in addition to the mid and large caps, would usually have higher expense ratios.

Blackrock also has a fund called the iShares Core MSCI Total International Stock ETF, which is one of their largest international funds, and uses the incredibly broad MSCI ACWI ex US Investable Market index as its reference, but only invests in about half of the companies in the index. This gives the fund an exposure to all developed and emerging economies, and all market capitalizations, but keeps the expense ratio very low.

Final words

Past returns don’t guarantee future results, but this 23-year review of fund performance shows why diversification is important, and how the I fund might benefit from being broadened. The difference of even a half of a percent in annualized compounded rates of return over a 30-or-40-year investing career can mean the difference of tens of thousands of dollars in retirement, and we don’t know which countries will outperform others going forward.

The TSP’s contracted asset manager Blackrock, Inc. already has experience managing large index funds that focus on these broader indices, and does so with low expense ratios by industry standards.

At minimum, it seems clear that the I fund would do well to switch from the MSCI EAFE index to one of MSCI’s World ex USA indices, which would simply add Canada to the fund and provide that slight bit of added diversification, while still keeping strictly to developed markets, and without having a significant impact on the fund’s expenses. Whether small caps are included or not doesn’t seem to make a significant difference for international returns, and it’s cheaper to exclude them. It would also be possible to add an “E fund” for separate emerging market exposure.

For a more complete world investment in one fund, the I fund could also reasonably switch to one of MSCI’s ACWI ex USA indices, which would add South Korea, Brazil, and a host of other emerging economies to the fund while still keeping the bulk of the assets in highly developed markets, and would broaden geographic exposure and further diversify the geopolitical risk of the fund.

The map would look like this:

Source: Blackrock

Either way, one of these changes would likely represent an improvement over the I fund’s current MSCI EAFE baseline.

Lyn Alden has a background in electrical engineering and engineering management, focusing on engineering economics, financial modeling and resource management. She shares investment strategy on her website,  LynAlden.com.

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