For many Thrift Savings Plan participants, the I Fund offers valuable diversification to their stock and bond investment portfolios. It might be a mistake to judge the attractiveness of the I Fund simply by looking at its average rates of return in comparison with the other TSP funds. The real value of the I Fund lies in the relatively low correlation of its annual returns with those of the others — its returns move out of sync with, and sometimes in opposition to, those of the C, S, F and G funds.
The I Fund’s performance is based on that of the Morgan Stanley Capital International EAFE (Europe, Australia, Far East) index, a broad collection of stock from companies in 21 developed countries outside the United States. The companies represented in the index include some of the largest and most respected in the world — BP Amoco, Toyota Motor, Nestle and Nokia. In addition to holding the stocks contained in the EAFE index, the I Fund holds cash and invests in futures contracts in an attempt to enhance returns.
The I Fund returns and losses primarily are generated by changes in the value of the stocks the I Fund holds and changes in the value of the U.S. dollar relative to the currencies of the countries in which those companies reside. Increases in the value of the dollar tend to depress the return of the I Fund, while a falling dollar tends to enhance the return. For example, nearly half of the I Fund’s 38.6 percent total return in 2003 was the result of decreases in the value of the dollar relative to foreign currencies. Dividends also contribute, although in a relatively minor way, to the fund’s returns.
The I 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 EAFE index and about foreign stocks in general, can be used to approximate how the fund would have performed and to estimate how it might perform in the future. For example, during 2004, the I Fund was the top performing TSP offering, returning 20 percent. During the five years ending Dec. 31, 2003, the EAFE index ranked fourth out of the five funds with an average annual loss of 0.1 percent. And, during the 10 years ending in 2003, the I Fund’s index produced a 4.4 percent average annual rate of return, the lowest of the TSP’s indexes. Longer-term data for foreign stocks, however, indicate an expected annual rate of return of about 12 percent, and long-term investors should be wary of predicting future returns on as little as 10 years’ worth of historical data.
Based on the historical data, the I Fund’s annual returns are likely to be quite volatile — at least as volatile as those of the C and S stock funds. But, the movements in value that are integral to that volatility have not always closely coincided with those of the other TSP funds. An important part of effective investment diversification is the concept of correlation — the degree to which an investment’s returns move in unison with its alternatives. Funds that are negatively correlated move more or less opposite to one another. Funds with no correlation move randomly to each other, and funds that are positively correlated tend to move in the same direction and at the same time.
Judging by the correlation data for the underlying indexes, the I Fund returns range between slightly negative to moderately positive in correlation with the other funds. At most, about 50 percent of the I Fund’s annual return can be explained, or predicted, by the return of any other TSP fund. More simply put, the I Fund can be expected to zig, or at least zag less, when the other funds zag. This characteristic is the essence of diversification and is critical to achieving superior risk-adjusted returns from your TSP portfolio.
In particular, combining the I Fund with the C Fund and, to a lesser extent, the S Fund can produce expected rates of return similar to either of the funds alone, but with significantly reduced volatility. All, or nearly all, of the return with less risk should be attractive to any TSP investor, but exceptionally attractive to those relying on their TSP account for a regular stream of income.
Written by Mike Miles
For the Federal Times
Publication March 7, 2005