Is There A Crash to Come For TSP?

There isn’t a platform that one can say has no room for improvement, but the Thrift Savings Plan still stands to be one of the best programs that are simple and low-cost if comparing to other investment savings accounts. They also have just updated their system by providing more withdrawal options for account holders based on feedback throughout the years.

 

The system does have some critics, though.

Readers who saw the movie, The Big Short, may recall the character which was based on real-life portfolio manager Michael Burry who shorted the housing market at the height of the 2007 real estate bubble, which made him insanely profitable returns for not only his clients but for himself as well.

Now, Burry himself is calling that the index funds may just be the next crash. What may be to blame? Overvaluation and overvaluation and liquidity mismatch.

Except for the G Fund, all other funds in the TSP are index. So, should account holders of TSP be worried about this claim?

Well, Burry is one of many prolific investors that does not support the rapid growth of index funds. Since these funds came to fruition in the ’70s by Vanguard, fund managers high-priced fees have been quite critical of these less costly automatic rivals. The reason? Probably because these index funds have a strong record of eclipsing performance due to their much affordable costs, which had lead to taking much of the market share from high-charging mutual funds.

A small minority of these fund managers exceeded passive investments with their perfomances, but as most things, there are usually exceptions to the standard. Mostly, investing is a zero-sum game compared to a standard such as the S&P 500, and most fund managers try to match the benchmark before the fees. Most of them end up underperforming once you take away the fees of about 1% per year.

Numerous 401(k)s in the U.S., along with many contractors working for federal branches, tend to be carried out through high-fee mutual funds that are not able to beat low-cost index funds.

Fees of 1% annually may seem negligible, but compounding the funds at 8% every year for four decades increases your investment by more than 21 times the principal amount, whereas compounding at just 7% per year for the same duration yields in under a 15-fold rise. If investments  end up being hundreds of thousands of dollars over decades, fees are not negligible at all.

Nevertheless, since index funds comprise an increasingly large portion of U.S. assets, it is worth examining concerns from Burry as well as others. Burry’s claim regarding index funds centers on two key problems which are: possible overvaluation and inconsistencies in liquidity.

Let’s look at overvaluation.

TSP funds, such as most index funds, are weighted by market capitalization, which means moving greater weight on the biggest and highest-valued companies. For instance, AEX and Apple are included in the C Fund, but because Apple’s market capitalization is about ten times bigger, it also weighs about 10x more in the C Fund.

Burry’s issue is that if trillions pour into index funds without enough market analysis of each stock, the biggest companies could be overweighted, which would have them overvalued. Burry believes in particular that stocks of large-cap growth are typically overvalued, and stocks of small-cap value are possibly viable bargains in the current financial climate.

This is a legitimate concern to a degree, but this has happened in the stock market before the existence of index funds. The U.S. stock market hit a peak in 1929 that it needed 27 years to achieve new inflation-adjusted market peaks after the market crash and the subsequent Great Depression. Furthermore, it required the market 24 years to achieve new highs adjusted for inflation after the market peak in1968. Also, it took 14 years to gain new highs taking inflation into account after the peak of 2000.

Diversifying is the primary preventative measure against this risk. For example, the TSP Lifecycle funds hold U.S. shares, foreign stocks, bonds, and automatically restructures the assets, helping them from being overly concentrated in areas of capital concentration.

Moreover, a lot of TSP participants have an IRA or other investments and can supplement their TSP with asset classes such as variables, investment trusts in real estate, emerging markets, precious metals, and definitely more. For instance, there are several exchange-traded funds, which allow shareholders to emphasize a particular area. For example, the SPDR S&P 600 Small Cap Value ETF enables shareholders to exclusively allocate to stocks with small caps.

Now let’s talk about liquidity mismatches.

The second point that Burry makes is that there is a liquidity mismatch with the funds and the underlying stocks. Most shares have only a few million dollars in the average amount of daily trading, but trillions of dollars are invested in index funds holding such stocks. If a huge amount of shareholders sell their index funds all at once (due to algorithmic trading, or TSP investors all switching to the G Fund during a market slump), this might lead to a point where sellers massively surpass buyers in amount for some of the less-liquid stocks within the fund, which could manifest into a large price difference.

That’s a fair observation. A historical instance of this happening in a single day happened in October 1987, the S&P 500 lost more than 22 percent of its value due to volatility that unfolded all at the same time. However, the market was not connected to index funds during this period.

Since that 1987 crisis, a good thing that came out of it is that the stock market has protections in place to minimize future liquidity-driven price problems like before. For instance, if stocks fall by 5% or 15%, many of these preventative measures will activate a process that will temporarily stop trading. This allows fund managers time to sort out what is happening and potentially allow dip-buyers to join in.

In addition, TSP participants tend to own other accounts that they can implement to broaden their investments.

The TSP offers a robust set of index funds for investors to create a fairly varied portfolio, which includes big and small U.S. corporations, foreign companies, bonds, and even G Fund Treasury securities. Although this does not cover all classes of assets out ther, it’s doing a fine job for investors overall.