A World of Problems

Adam M. Grossman

WITH EVERYTHING that’s been going on recently, one story that’s 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 had been a ceasefire in the debate, but it isn’t over. It’s worth understanding what’s at stake—because the underlying issue has been a recurring theme in the investment industry.

If you aren’t familiar with the TSP, it’s one of the retirement plans available to federal government workers. In lots of ways, it’s similar to a private sector 401(k). It allows employees to contribute part of each paycheck. The government also makes contributions. Employees can choose from a menu of investment options.

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 tracks the MSCI Europe, Australasia and Far East index. But a few years ago, the TSP proposed shifting to a new index called MSCI ACWI ex USA Investable Market index.

While these names might sound similar, there’s 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 so it could purchase these new emerging markets holdings.

As you might imagine, it’s 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’s a 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, let me first provide some background: People often laud the merits of index funds—for good reason. Year after year, studies show that most actively managed funds lag behind their benchmarks. As a result, many investors now take it on faith that index funds are the better choice. 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 said 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 its own business purposes and not for valid investment reasons. Whatever the explanation, I called it out at the time because of the negative impact on investors in terms of both diversification and taxes.

Indeed, whether its MSCI’s change last year or the TSP’s proposed change, in both cases the governing bodies are imposing big changes on existing shareholders without giving them a chance to vote or the opportunity to opt out. On the TSP website, there’s just a small, innocuous-looking link that reads “Investment benchmark update,” but no option to remain with the old investment strategy. I asked one TSP participant, who is an I Fund shareholder, whether he had received any communication about the change. His response: “Zip nada nil.”

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’s merely his opinion. It may be an informed opinion, but in the world of investments there are no guarantees.

In my view, it isn’t right to pull the rug out from under existing shareholders in this way after they’ve already chosen a fund to fill a specific role in their portfolio. This is especially true since there’s such an easy alternative: The TSP could simply create a new fund for investors who want to add emerging markets exposure. That’s 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 the change on hold—and that’s a good thing. But let’s face it: The outcry is only happening 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: As an individual investor, 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. 

Adam M. Grossman’s previous articles include Thinking It ThroughRegrettable Behavior and Defending Yourself. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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