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Best TSP Allocation and Strategy


Hello, I'm Michael Bond and welcome to my site developed for serious and reluctant TSP investors.  I earned a degree in Investment Finance prior to my career in the US Air Force.  I've spent two decades following the markets closely and now write about what I unlearned and learned about how the markets really work.


I am going to walk you through the TSP funds from a different perspective than you may find anywhere else. 


I've spent years reading a lot of faulty analysis about investing in the TSP funds and the stock and bond markets in general.  Much of it comes from an academic or marketing perspective and not from basic real-world analysis. Nothing I am about to present requires a rocket scientist to understand.  


We are just going over some facts that are rarely discussed.




Part 1: Eliminating the Weaker Funds




Chasing past returns is not a good long-term strategy



Do you drive your car by looking in the rear-view mirror?  You should not invest that way either - stop looking to past returns to determine where to invest in the future.  







Look Forward



There are five basic funds in the TSP that one can allocate to plus the Life Cycle funds that allocate among the basic five funds based on your years to retirement using an academic portfolio theory. We will talk about the Life Cycle funds below but first we need to focus on the five basic funds. We can do a pretty good job determining the winners going forward long-term based on what's under each fund's hood.  Let's start by eliminating the less desirable funds from the mix.



Comparing the two low-risk funds


With an exception I consider the TSP F fund the less desirable low-risk fund for long-term investors at this point in history.  The TSP F fund will under-perform the TSP G fund while interest rates are rising and out perform only when rates are falling. And since the TSP F fund’s yield is usually very close to the TSP G fund’s interest rate, it will match the G fund when interest rates are flat. The TSP G fund does not contain default risk making it a better choice during flat or rising interest rate environments.


The difference in performance of these two funds are the capital gains or losses the F fund sustains during the year due to interest rate movements.  So unless interest rates are falling (F fund price rises), there is no reason to be in the F fund over the G fund.  This may explain why the TSP Lifecycle Income Fund for retirees currently holds 74% G fund and only 6% F fund.


From the F fund’s inception until 2012, interest rates were declining and the F fund’s price went up due to the falling rates.  While this makes the F fund’s past performance look good when comparing it to the G fund, this has not been the case since 2012.  Since 2012 interest rates have put in three bottoms, one in 2012-13, then 2016 and recently in 2019.  The price difference in this fund after taking out the yield for these three bottoms in interest rates was within 1.5% of each other. Meaning the TSP F fund price has been on an interest rate roller coaster since 2012 and all the gains have come from its yield peak to peak.

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We saw downward pressure on interest rates in 2019 - a slowing global economy an increased financial stress.  Interest rates on the 10-year US Treasury bounced off the same level of the last two lows.  Holding the TSP F fund at the end of 2019 is a bet that interest rates in the US will plunge to record lows which implies a negative forward outlook for the US economy and financial situation. 


The main point here is that over the long-term interest rates determine whether the F fund is a better place to park your funds over the TSP G fund.  Sitting near historic lows in interest rates I don't consider this a sound long-term bet.  Short-term can be a different story.


It is important to understand that you will often see short term bounces in the F fund when the stock market sells off.  Investors are simply running to safety and this causes a very short-term bump in the safer fixed income prices.  This does not occur for the TSP G fund because it does not hold real securities - it is a virtual fund and its interest rate is based on a formula.



When investors return to the stock market, the bump in the TSP F fund often disappears.  So for long term investors, the trend in interest rates is what matters. Last year I said the trend of declining interest rates bottomed in 2016 and was set to move higher through 2020 or at least until the next financial crisis. We are now seeing indications the financial crisis is bubbling up. The plunge in interest rates this year (rise in F fund price) was the result of global financial stress.  


So if you expect another financial crisis, does this mean the TSP F fund will become a better performing fund. Yes, but be careful. Bond funds come with both interest rate risk and default risk, the default risk during financial crisis means you should return to the risk-free TSP G fund after interest rates bottom.






Forget the international fund (TSP I fund)


Note: I define a "long-term investor" as someone who does NOT chase short-term movements in the market.  An investor, not a speculator.


The other fund that long term investors should avoid is TSP’s International fund.  The I fund is transitioning to broader international exposure in 2019. There is an ongoing battle between some Senators and the TSP managers over the inclusion of China into the TSP I funds portfolio and currently the TSP managers signaled they are going ahead with the expansion.  This is not why I do not recommend the I fund, but it does add to the case a bit.


The TSP International (I) Fund will now include more emerging markets the largest being China.  Adding emerging markets does compliment the TSP US equity funds from a geographic diversification point-of-view.  But diversification into under-performing sectors is not a benefit and remains the same with the new index it may track.


While I expect Chinese companies to suffer under the trade war, the biggest problem is the lack of rigorous accounting and oversight in China.  Many Chinese companies will not be standing after the next global financial crisis.  This has more to do with financial falsifications than a simple recession.  Chinese companies are stating cash and other assets they do not have.  One of their top auditing agencies has been caught knowingly signing off on fraudulent accounting records.  Not to over-state China, its contribution to the I fund should top out around 7% in the near term.


The best performing sector in world has been technology and this is the primary weakness of the TSP I fund.  And guess where the world’s preeminent tech companies are listed?  They are listed in the US where their returns are captured by the SP500 index which is tracked by the TSP C fund.   


The International index (TSP I fund) is weighted with only 8% tech compared to the TSP C fund's 20% weighting.  It is those top 100 largest Nasdaq listed companies that are tracked in the SP500 index that helped the TSP C fund pull ahead of the TSP I fund.  These are the most profitable growth companies in the developed world and they sit in the TSP C fund.

 




The SP500 companies as a whole obtain 31% of their revenue outside the US, meaning the SP500 is already diversified internationally.  Better yet the SP500 tech sector obtains 57% of its tech revenue outside the US.  When you add the I fund to your allocations, you are quickly under-weighting the world's large tech stocks.


The TSP I fund is also holding over a 24% weighting in financial stocks and frankly Europe’s banks and finances are a bug looking for a windshield.  The European Central Banks manipulation of interest rates into negative territory merely covered up the European problems in the short run with little positive effect on their economy.  


If interest rates do not rise above inflation, European savers will be crushed and the demand-side of the economy will suffer. Simply put, I do not see the TSP I fund as a good long-term investment for 2019 and beyond.


While the US stock market is more over-valued today, the global stock markets were highly correlated to the downside during the last two bear markets - meaning you can not hide in international stocks when the US stock market rolls over into a bear market.


Adding emerging markets adds an additional risk to the I fund.  My concern on emerging markets are the lack of protections for investors in some markets which may occur during another financial crisis.




What about the Lifecycle funds?


The Lifecycle funds follow a buy and hold strategy and are simply invested in all five basic funds to include the two we think should be eliminated from the mix.  The funds are predominately invested in equities until you close in on retirement where they start shifting to the TSP G fund -- 74% in the retirement income producing fund. 


The two ovals in the next chart highlight a key point about most Lifecycle funds.  They do lose less during bear (down) markets, but the gain less during bull (up) markets. This means they are less "volatile" and this is advertised as being less risky.  With the exception of the Retirement Income Lifecycle fund you run the risk of large losses during bear markets.  You also get the under-performance of the two worst funds during bull markets.  You can do better.


TSP Lifecycle Funds


The Life cycle funds hold proportions of each equity fund (TSP C/S/I) based on their market valueWhile the equity funds are diversified geographically across the developed world based on a value weighted basis, this geographic diversification under-weights global technology relative to holding the US only equity funds.  With the addition of emerging markets to the TSP I fund, the increased market value of this fund means the Lifecycle funds will hold a higher allocation to the I fund than before and a lower allocation of the US equity funds. 




So to keep it simple we've now narrowed our decisions down to only 3 funds to consider - the TSP C and S equity funds and the no-risk G fund... (the one exception is to temporarily hold the F fund over the G fund during declining interest rates)



...let's take a look at Part 2: The three best funds.




Testimonial #1


TSPSmart-

I can’t read enough!  You are saying all of the things I have been saying!  I have been successful for quite some time at stocks, but starting last December, I lost my read of the market.  Your writing is spot on and largely correct at guessing the future direction.  Love the service.  Naval aviator with an interest in finance…sounds familiar.  


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