With everything that’s been going on recently, one story that has received less attention is the ongoing spat between the White House and the board of the Thrift Savings Plan (TSP). As of a few days ago, there has been a ceasefire in this debate, but it isn’t over. And because the underlying issue has been a recurring theme in the investment industry, it’s worth understanding.
If you’re not familiar with it, the TSP is one of the retirement plans available to Federal government workers. In a lot of ways, it’s similar to a private sector 401(k): It allows employees to contribute part of each paycheck, and the government also makes contributions. Employees can then choose from a menu of options to invest their funds.
The current debate centers on a proposed change to one of those investment options, called the I Fund, which, as you might guess, invests in international stocks. Currently, the I Fund is designed to follow an index called MSCI Europe, Australasia and Far East. But a few years ago, the TSP proposed shifting the fund to a new index called MSCI ACWI ex-U.S. Investable Market index.
While these names might sound similar, there is a big difference: The old index was limited to major developed economies, including France, Germany, Japan and Australia. Meanwhile, the new index also includes stocks from 26 emerging markets countries, including Russia, Indonesia and China. To implement this change, the I Fund would have to sell a substantial share of its existing developed markets holdings in order to purchase these new Emerging markets holdings.
As you might imagine, it is the addition of China that the administration opposes. But from an investor’s perspective, this is about more than politics. To be sure, I don’t love the Beijing government, and that is one valid reason to oppose this change. (Opposition, in fact, has been bipartisan.) But the concern I want to address here centers on the investment impact.
To explain my concern, I’ll first provide some background: People often laud the merits of index funds—and for good reason. Year after year, studies show that most actively-managed funds fall short of their benchmarks. As a result, many investors now take it on faith that index funds are the better choice. And for the most part, I agree.
Unfortunately, index providers are businesses too—big businesses, in fact—and have their own motivations that sometimes put them at odds with the interests of investors. Last year, for example, index provider MSCI made a dramatic change to its Emerging Markets Index, boosting its allocation to Chinese stocks. Unlike the I Fund, this index already included Chinese stocks, but this decision increased their representation substantially. Two years ago, China accounted for less than 30% of that index. Today that number is nearly 40%, and MSCI has previewed that it may increase further.
To be clear, the composition of indexes changes all the time, as constituent stocks rise or fall in value. But the change MSCI made last year was different; this was a subjective policy change—like Coca-Cola changing its recipe. Some, including The Wall Street Journal, have argued that MSCI made these changes to suit their own business purposes and not for valid investment reasons. Whatever the reason, I called it out at the time because of the negative impact for investors in terms of both diversification and taxes.
That is at the heart of my concern here. Whether its MSCI’s change last year or the TSP’s proposed change, in both cases the governing bodies are imposing changes on existing shareholders without giving them a vote or the opportunity to opt out. (On the TSP website, there is just a small, innocuous-looking link that reads “Investment benchmark update” but no option to remain with the old investment strategy.)
To be sure, the TSP board believes that changing the I Fund in this way will benefit shareholders: “Moving to the new benchmark could improve the expected return and diminish the expected risk for participants,” writes Michael Kennedy, chair of the TSP’s investment board. But that is merely his opinion. It may be an informed opinion, but in the world of investments there are no guarantees. For that reason, in my view, it isn’t right to pull the rug out from under existing shareholders in this way after they have chosen a fund to fill a specific role in their portfolio. This is especially true since there is such an easy alternative: The TSP could simply create a new fund for investors who wanted to add emerging markets exposure. That is very common in other retirement plans. Similarly, MSCI could create a new index for those who preferred a heavier weighting of Chinese stocks in their portfolios.
For now, the TSP board has put this change on hold, and that’s a good thing. But it’s only because of the TSP’s high profile, as a government program with five million participants. In many cases, changes like this sail right through without anyone noticing or objecting.
The lesson: Unfortunately, as an individual investor, this means you can’t take anything for granted. While index funds have a good, and well-earned, reputation, that doesn’t mean they’re infallible. Always be sure to look under the hood of a prospective new investment by checking the fund company’s website. And make it a practice periodically to review existing investments to make sure no one has quietly substituted New Coke in place of the old.