Unless you expect to deplete your Thrift Savings Plan account within the next few years, the S Fund should be part of your TSP investment strategy. Like the C Fund, which tracks the performance of the Standard & Poor’s 500 stock index, the S Fund is an index fund that tracks the aggregate performance of a large number of domestic stocks. The S Fund tracks the performance of the S&P Wilshire 4500 Completion index, which is made up of the approximately 4,500 U.S. stocks not already included in the S&P 500. Although it is commonly considered a small-company stock fund, the S Fund tracks the performance of many large, well-known and respected companies, including Berkshire Hathaway,
Amazon.com, Genentech, Hughes Electronics and Cox Communications. The fund’s exceptionally low annual expenses — 0.1 percent as for all TSP funds — mean that its returns will closely track those of the underlying index.

The bulk of the S Fund’s returns come from the change in value of the underlying stocks, with a small, but always positive, contribution coming from dividend income. Like the I Fund, the S Fund was added to the TSP lineup in May 2001, so performance data for the fund itself is not available before that date. But, information about the underlying index, and about small and mid-cap stocks in general, can be used to approximate how the fund would have performed and to estimate how it might perform in the future.

The S Fund was the top-performing TSP offering in 2003, returning nearly 43 percent. Over the five years ending Dec. 31, 2003, the Wilshire 4500 index returns show the S Fund would have ranked first out of the three TSP equity funds with an average annual gain of 4.1 percent. And, during the 10 years ending in 2003, the S Fund’s index produced a 9.8 percent average annual rate of return, which would have placed the S Fund second to the C Fund over the same period. Long-term investors should avoid predicting future returns on as little as 10 years’ worth of historical data, however, since market cycles can last 10 years or more. Longer-term data for small cap stocks, however, support an expected annual rate of return closer to 17 percent.

Based on the historical data, the S Fund’s annual returns are likely to be quite volatile — more volatile than any of the other TSP funds. So, on its own, the S Fund carries quite a bit of short-term risk. Based on historical statistics for small cap stocks, an investor should expect to see a negative annual return from the S Fund in about three of every 10 years, and the loss can be expected to be 40 percent or more in about three out of every 100 years. This means that, in exchange for the downside risk, the S Fund can be expected to deliver positive results in about 70 percent of future years. These positive results can be quite impressive, with annual gains approaching or exceeding 40 percent in about three out of every 10 years.

By itself, the S Fund is a risky investment, but used in combination with the other TSP funds, it can help to enhance long-term rates of return without a corresponding increase in portfolio risk. This is because the S Fund’s behavior is not perfectly correlated with any of the other funds. It sometimes goes up when the other funds go down and vice versa. Some of the fund’s volatility is canceled out by the uncorrelated volatility of the other funds, reducing the volatility actually experienced by the portfolio. In short, you get the full benefit of the fund’s higher expected rate of return without experiencing the full effect of its volatility, or risk. This correlation characteristic is a key element of designing optimal investment portfolios and is too often overlooked or misunderstood by investors.

Predicting stock returns accurately is impossible. But, predictions about long-term behavior are generally more reliable than those for returns over the short run. It is more likely that the S Fund will deliver the expected annual rate of return during the next 60 years than during the next 10, for example. Correspondingly, the past 60 years of results is a more reliable predictor of future returns than using one, five or 10 years of history. Deciding which funds to include in your portfolio based on the recent past can counterproductive, or even disastrous in the extreme. Using rationally developed expected, rather than past, returns to make investment decisions will yield more reliable long-term results.

In the model portfolios I create for clients, which are developed to try to maximize the expected return for the amount of risk taken, the allocation to small and mid-cap stocks ranges from 65 percent in the most aggressive portfolio to 7.5 percent in the most conservative. So, even the most conservative portfolio, appropriate for assets that are likely to remain invested for at least three years, can benefit from anallocation to the S Fund.

Written by Mike Miles
For the Federal Times
Publication March 21, 2005