Investment Option Review 

Federal Retirement Thrift Investment Board 

Thrift Savings Plan 

February 2013

Hewitt EnnisKnupp, An Aon Company 

© 2011 – Aon Corporation 
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Table of Contents 

Page 

1 Executive Summary 1 

2 Review of Current Circumstances and Comparison to Peers 9 

3 Investment Structure 19 

4 Key Evaluation Criteria for Investment Fund Alternatives 25 

5 Application of Key Criteria to Investment Fund Alternatives 33 

6 Non-U.S. Bonds 49 

7 U.S. Stocks 55 

8 Emerging Markets Stocks 61 

9 Global REITs 69 

10 Commodities 77 

11 Emerging Market Bonds 85 

12 Non-U.S. Small Cap Stocks 93 

13 Appendix 101 
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1 

EXECUTIVE SUMMARY 
2 

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EXECUTIVE SUMMARY 

 3

Background 

The Federal Retirement Thrift Investment Board (FRTIB) asked Hewitt EnnisKnupp to review the line-up of 

funds offered within the Thrift Savings Plan (TSP) to determine whether the line-up remains appropriate 

and to evaluate whether potential fund additions are warranted. 

In this report, we: 

 Review the circumstances of the Thrift Savings Plan and compare its circumstances to that of peer 

plans 

 Identify the key criteria to evaluate potential fund additions 

 Apply the key criteria to a broad array of potential fund alternatives to identify those suitable for further 

consideration 

 Review the appropriateness of including specific fund alternatives and provide our recommendations 

on whether a fund alternative should be included in the Plan line-up 

Current Practices and Peer Comparisons

 As of December 31, 2012, the TSP had approximately 4.6 million participants who had approximately 

$330 billion invested among the underlying plan options. This translates to an average participant 

balance of approximately $70,000. 

 The TSP offers ten investment alternatives for participants to choose from. These include five core 

investment alternatives and five lifecycle or target retirement date funds. 

 The table below lists the investment options currently offered within the Thrift Savings Plan 

Fund Type TSP Fund 

 Stable Value G Fund 

 Diversified Fixed Income F Fund 

 Lifecycle/Balanced L Income 

 L 2020 

 L 2030 

 L 2040 

 L 2050 

 U.S. Stock C Fund 

 S Fund 

 Non-U.S. Stock I Fund 
EXECUTIVE SUMMARY 

 4

Investment Structure 

By investment structure, we refer to the number and types of options that are offered within a plan. We 

believe a plan’s investment options should offer a sufficient range of choice to allow participants to form 

well-diversified portfolios, given a reasonable range of risk and return circumstances. As such, we believe 

that the TSP should have a structure that: 

 Offers sufficient range of choice – with options that reasonably span the risk and return spectrum 

 Allows participants to form well-diversified portfolios 

 Is appropriately comparable with peers 

 Meets broad participant demand 

The investment fund types offered to TSP participants match those that we recommend the TSP offer. 

 U.S. stock 

 Non-U.S. stock 

 Diversified fixed income 

 Cash equivalent/stable value 

 Lifecycle 

Our recommendations regarding the TSP’s investment structure are also influenced by our beliefs that: 

 Employee education is one of the most important components of a successful defined contribution 

plan 

 The number of options should not overwhelm participants 

 The more broadly diversified an asset class/asset category, the better it will serve participants over the 

long-term 

 Participants should be provided with two decision-making paths – an array of lifecycle funds and an 

array of broadly diversified asset class/asset category specific funds 
EXECUTIVE SUMMARY 

 5

Review of the TSP’s Investment Structure 

 The five core investment alternatives span the risk/return spectrum and include what we would 

consider to be all of the core building blocks to build a diversified investment portfolio. With the 

exception of the G Fund, each of the core investment options is broadly diversified and provides 

comprehensive coverage of the asset class it represents. The G Fund, while not broadly diversified 

since it has exposure to a single issuer, the U.S. Treasury, is backed by the full faith and credit of the 

U.S. Government. 

 The L Funds include an Income Fund and four target retirement date funds offered in 10-year 

increments commencing with a fund with a target retirement date of 2020. The L Funds allow 

participants to select an investment fund that is diversified among and within asset classes as the L 

Funds are constructed using the five core investment options. 

 While the number of options offered within the Thrift Savings Plan is lower than that of peer plans, we 

believe that the TSP offers investment funds across the major categories that are found in a majority of 

participant directed plans and represent the investment options in peer plans. 

 Moreover, the options offered within the TSP represent those that receive a large portion of the assets 

in peer participant directed plans. 

 As noted earlier, we believe that the options offered also represent the core building blocks necessary 

to build a diversified investment portfolio. 

One of the hallmarks of the Thrift Savings Plan is its simplicity and efficiency. The Plan offers low-cost, 

broadly diversified options that provide coverage of the broad asset class segments that form the core 

building blocks of diversified portfolios. The core options allow participants to build portfolios that span the 

risk and return spectrum. Further, offering the L Funds is in line with contemporary best practices and 

allows participants who do not wish to make investment decisions pre-mixed portfolios that embrace the 

key tenets of investing (diversification, appropriate risk/return profile, and low cost). 

We believe that the options offered represent the major categories found in peer plans and the options to 

which most participant assets are directed. In terms of broader industry trends, after years of offering an 

increasingly wide number of options from which participants can choose, we find that increasingly plan 

sponsors are seeking to streamline their plans and are focusing on simplicity and efficiency. This has led 

to, for the first time in years, a reduction in the average number of plan options offered across a broad 

range of participant directed defined contribution plans. Hewitt EnnisKnupp’s advice to our defined 

contribution clients is to maintain a simple efficient investment line-up that includes target retirement date 

funds, passive options that provide broad asset class coverage, and select, broadly-diversified active fund 

options. With the exception of active fund options, the TSP line-up is reflective of the broad advice we 

provide clients in structuring their defined contribution plan line-up. 

We believe that the core of the TSP’s line-up is well-structured and that there are no gaps in the fund lineup offered to participants. 
EXECUTIVE SUMMARY 

 6

Key Criteria For Evaluation of Investment Fund Alternatives 

In evaluating the types of investment fund alternatives to offer in the TSP, we believe the following criteria 

(individually and collectively) are the most relevant to consider: 

 Major diversified asset class/category not currently offered as an investment option 

 Asset class/category is large enough for the TSP to invest in (consider asset classes/categories with a 

market capitalization or investment opportunity set of at least $1 trillion) 

 Potential diversification benefit for TSP participant portfolios 

 Asset class/category offers daily liquidity 

 Exposure to the asset class/category can be derived on a passive basis

 Practices of peers 

Review of Asset Classes/Categories Considered for Inclusion 

The asset classes/categories we considered for review are listed in the table below. 

Equities Fixed Income Alternatives/Other 

U.S. Growth Stock Non-U.S. Bonds Private Real Estate 

U.S. Value Stock High Yield Bonds Private Equity 

Global REITs TIPS Commodities 

Emerging Market Stock Emerging Market Debt Hedge Funds 

Non-U.S. Small-cap Stock Socially Responsible/ 

Frontier Markets Corporate Governance Funds 

 Infrastructure 

Based on the application of the key criteria discussed above, we eliminated several categories from further 

consideration due to factors such as – small market size, illiquidity, lack of passive investment strategies, 

concentrated strategies, or the TSP participants already gain access to the category through existing 

investments. The asset classes excluded for further consideration were: 

 Frontier Market Equities 

 High Yield Bonds 

 Private Real Estate 

 Private Equity 

 Commodities 

 Hedge Funds 

 Socially Responsible/Corporate Governance Funds 

 Infrastructure 

We also excluded TIPS from further consideration. TIPS are an attractive asset class for investors who 

seek to hedge against the risk of inflation. The TSP offers a fund (G Fund) that provides similar 

characteristics over the long-term without negative price volatility associated with a TIPS fund. 
EXECUTIVE SUMMARY 

 7

Additionally, a TIPS fund would provide limited diversification benefits to TSP participants, add complexity 

to an investment category where we believe additional flexibility is not required, and is not common 

practice among peer plans. Therefore, we recommend the FRTIB not offer TIPS as an investment fund 

alternative. 

Below we provide summary thoughts on the asset classes/categories that we reviewed in detail. 

Non-U.S. Bonds 

Non-U.S. bonds are a material portion of the world’s market capitalization and investable opportunity set. 

However, the benefits of adding a non-U.S. bond option are minimal from an expected risk-return and 

portfolio diversification standpoint for TSP participants. Moreover, adding a non-U.S. bond fund would add 

complexity to a segment of the plan where we believe additional flexibility is not required and/or 

meaningful. As such, we recommend the FRTIB not add a non-U.S. bond fund as an investment fund 

alternative. 

Value and Growth U.S. Stocks 

Larger-capitalization growth and value funds are attractive alternatives from a market size, liquidity, sector 

and a security diversification standpoint. The diversification benefits from a portfolio standpoint, however, 

would not be material relative to the current investment funds already available. We do not believe it is 

necessary for the TSP to offer any additional U.S. stock funds as the C and S Funds provide exposure to 

the entire U.S. stock market. Offering a more limited number of U.S. stock funds without foregoing material 

improvement in portfolios would be consistent with avoiding investment choice overload. On balance, we 

do not find a compelling reason to add additional U.S. stock funds, as the TSP’s current investment line-up 

provides broad exposure to the U.S. stock market via the C and S Funds. The same thinking applies with 

value and growth stocks in non-U.S. developed markets as well. 

Emerging Market Stocks 

Emerging markets are a large asset class, expected to experience secular growth, and provide a benefit to 

portfolios at the higher levels of risk. While emerging markets are an attractive asset class, we have 

concerns with the TSP (and DC plans in general) offering emerging markets as a standalone investment 

fund. The high risk associated with emerging markets has resulted in material losses over relatively short 

periods of time and is difficult for participants (or for any investor) to bear. Additionally, there are limited 

benefits to adding emerging market equities to well-diversified low to moderate risk portfolios. Overall, we 

believe the negatives of offering an emerging markets investment fund outweigh the positives and 

recommend an emerging market stock fund not be added as an investment fund alternative. 

Global REITs 

While there appear to be compelling attributes supporting the inclusion of global REITs, we do not 

recommend their inclusion at this time. As noted, TSP participants attain exposure to REITs in market 

capitalization weights via the C, S and I Funds. REITs are a specific sector of the global equity market and 

exhibit a higher degree of volatility than the broad equity market. Adding REITs would make the plan lineup more complex. While the number of plans offering a REIT option has increased, utilization has 

remained low. 
EXECUTIVE SUMMARY 

 8

Commodities 

Commodity futures offer a diversification benefit, as well as the potential to hedge against inflation. 

However, commodity prices are influenced by demand/supply considerations rather than the intrinsic value 

of a security, and future return expectations are uncertain. Most individual investors will have difficulty in 

determining an appropriate allocation to commodities. Commodity funds are also not a common 

investment option in defined contribution plans. We recommend that the FRTIB not offer commodities as 

an investment option in the TSP. 

Emerging Market Debt 

While correlations to traditional bonds are low, correlation to equities are fairly high, coupled with lower 

expected returns and high risk, this asset class is less appealing as a stand-alone option. Offering 

emerging market debt, as a stand-alone option, is not common practice (none of the top ten largest 

government plans offer this option). For these reasons we would not recommend emerging market debt 

be added as an investment fund alternative. 

Non-U.S. Small Cap Stock 

While non-U.S. small cap markets have grown to an adequate size and index products are now offered, 

we would prefer to take a more broadly diversified view of international stocks. More broadly defined 

investment options will make education easier and participation more likely. Non-U.S. small cap may rank 

second, next to emerging market equity, as one of the higher risk offerings and is not commonly offered, 

as a stand-alone investment option. The high risk associated with non-U.S. small cap stocks may result in 

material losses. We do not recommend non-U.S. small cap stock be included as a stand-alone investment 

fund.

Conclusion 

Based on our analysis, we did not find any of the seven asset classes/categories that we evaluated in 

detail particularly compelling as an investment fund addition to the TSP line-up. The simplicity and 

efficiency of the existing line-up makes the TSP a very attractive offering to participants. We do not believe 

that the addition of any of these options offered would enhance the efficiency of the Plan without 

compromising materially on its simplicity. As such, we recommend that the FRTIB maintain the existing 

structure of its investment line-up and not add any additional investment option to its line-up. 
 9

REVIEW OF CURRENT CIRCUMSTANCE AND COMPARISON TO PEERS
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REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

 11

The following section encapsulates the current circumstances of the TSP's investment structure and 

compares it to peer plans. 

Overview 

 Assets of approximately $330 billion as of December 31, 2012 

 Over 4.6 million participants 

 An average participant balance of approximately $70,000 

 10 investment options are currently available to participants (5 core options and 5 lifecycle or 

target date funds): 

Fund Type TSP Fund 

 Stable Value G Fund 

 Diversified Fixed Income F Fund 

 Lifecycle/Balanced L Income 

 L 2020 

 L 2030 

 L 2040 

 L 2050 

 U.S. Stock C Fund 

 S Fund 

 Non-U.S. Stock I Fund 

Key Characteristics of TSP 

 The TSP offers participants the ability to invest in five diversified “core” investment alternatives 

(G, F, C, S and I Funds) that reasonably span the risk and return spectrum, allowing participants 

to construct portfolios that range from low risk to moderate to higher risk. We note the G Fund is 

not “diversified” among securities, but is backed by the full faith and credit of the U.S. 

government. 

 The L Funds allow participants to select an investment fund(s) that is diversified among and 

within asset classes, as the L Funds are constructed using the five underlying core investment 

funds. Importantly, the L Funds embrace the key principle of investing in that they are broadly 

diversified. The L Funds rebalance and evolve over time from growth-oriented portfolios to 

income and principal-preservation focused portfolios in order to adjust for participants’ time 

horizons. 

 The costs of administering the TSP’s total plan are well below industry average (under 5 basis 

points or 0.05%). Investment fees for most other plans range from 0.50% to 0.80%. We rarely 

observe total investment fees below 0.45% for participant defined contribution plans. 
REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

 12

On the following pages, we compare the practices of the TSP to those of peer defined contribution 

plans. In order to compare the TSP to an appropriate sub-set of peers, we use information from two 

widely followed defined contribution surveys – Profit Sharing/401(k) Council of America (PSCA) and 

Vanguard – both of which provide information on private sector 401(k) plans. In addition, we 

compiled information on the offerings of the ten largest public sector (and quasi-public sector) defined 

contribution plans shown in the table below. 

Top Ten Public Sector (Quasi Public Sector) Savings Plans by Assets 

Name of Fund Market Value ($Billions) 

New York Retirement Systems $20.8 

University of California Retirement Systems 11.3 

Washington State 9.9 

New York City Investment Board 9.9 

Ohio Public Employees Deferred Compensation 7.9 

California State Savings Plan 7.2 

County of Los Angeles 7.1 

State Board of Administration Florida 6.4 

North Carolina Retirement Systems 5.7 

Indiana Public Retirement System 5.5 

Observations 

 From a practical standpoint, it is worth noting that while peer comparisons provide a good 

reference point, the large size of TSP’s assets limit the options that can be offered to participants 

due to the size and liquidity attributes of a potential offering’s market capitalization/opportunity 

set. Moreover, the TSP’s governing statute and Board policies (such as offering passive options), 

limit the number of options that can be made available to participants. 
REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

 13

The table below shows the types of investment options commonly offered to participants. 

Investment Options Commonly Offered 

Fund Type 

TSP 

PSCA (5,000+ 

Participants) 

Vanguard 

(5,000+ 

Participants) 

Top 10 Public 

Sector Plans 

Balanced Fund No 54% 74% 60% 

Bond Fund – Active 

Bond Fund – Passive 

International Bond 

TIPS* 

High Yield 

No 

Yes 

No 

Yes 

No 

77 

58 

13 

N/A 

N/A 

67 

85 

N/A 

40 

22 

100 

50 

0 

40 

10 

Cash (CD/Money Market)* Yes 39 64 40 

Company Stock No 52 43 0 

US Equity – Active 

US Equity – Passive 

US Large Cap Value 

US Large Cap Growth 

US Mid Cap 

US Small Cap 

No 

Yes 

No 

No 

No 

No 

85 

90 

N/A 

N/A 

N/A 

N/A 

93 

99 

88 

92 

80 

81 

70 

100 

50 

50 

70 

100 

International Equity – Active 

International Equity – Passive 

Emerging Markets 

No 

Yes 

No 

80 

48 

N/A 

88 

56 

25 

80 

60 

30 

Target Date/Asset Allocation Fund Yes 75 91 90 

Real Estate Fund No 22 26 10 

Stable Value* Yes 80 64 90 

Self-Directed (Brokerage/Mutual 

Fund) No 32 21 30 

Socially Responsible No N/A N/A 60 

Source: PSCA 49th Annual Survey of Profit Sharing and 401(k) Plans (20011 Plan Experience), 

Vanguard 2011, Hewitt EnnisKnupp 

*For the purpose of this analysis, we classify the G Fund, offered within the TSP, to represent three 

options – money market, stable value and TIPS – since it provides benefits and/or attributes 

associated with each of these categories. The G Fund adjusts almost immediately to changes in 

interest rates (without any principal volatility), which may be a result of rising inflation (TIPS), provides

daily liquidity (money market), and provides higher yields than money market without risk of loss to 

principal (stable value). 
REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

 14

Observations 

 The TSP offers investment options in the most widely provided categories. 

 The areas where TSP does not offer options that are commonly utilized by peers include US 

large cap growth/value, active equity and active bonds. Exposure to the market return (beta) that 

these active funds provide can be gained through passive domestic/international equity and 

passive bond funds (funds C, I & F). On this issue, it is important to note the research that we 

and others in the industry have conducted shows that a vast majority of active funds fail to add 

value net of fees. As such, we do have a bias toward utilizing passive investments/funds, 

especially in defined contribution plans. 

 Socially Responsible Investment (SRI) funds are offered by a majority of the largest public sector 

defined contribution plans, however, most of the exposure to stocks that such funds provide can 

be gained through the C, S & I funds as SRI is a subsector of equities and not a distinct asset 

class. 

 Balanced funds are offered by the majority of large defined contribution plans, however, most of 

the exposure can be obtained by using the L Funds or a combination of C, S, I, F and G funds. 

In the following tables, we show the participant asset allocation practices according to the three 

marketplace surveys mentioned earlier. 

PSCA: Participant Asset Allocation 

Plans with 

5,000+ 

Participants 

Allocations 

Excluding 

Company Stock 

TSP 

Cash (CD/Money Market) 

Stable Value 

Bonds – Active 

Bonds – Passive 

International Bonds 

4% 

16 

5 

3 

0 

5% 

20 

6 

4 

0 

-- 

43 

-- 

8 

-- 

Total Fixed Income 28 35 51 

Company Stock 

US Equity – Active 

US Equity – Passive 

International Equity – Active 

International Equity -- Passive 

22 

16 

12 

4 

2 

-- 

20 

15 

6 

2 

-- 

-- 

30 

-- 

5 

Total Equity 56 43 35 

Balanced 

Sector Funds 

Self-Directed 

Target Date/Lifecycle 

Other 

6 

0 

1 

8 

1 

7 

0 

1 

11 

1 

-- 

-- 

-- 

14 

-- 

TOTAL 100% 100% 100% 

Source: PSCA 55th Annual Survey of Profit Sharing and 401(k) Plans (2011 Plan Experience) 
REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

 15

Observations 

 TSP participants have significantly less allocated to equities than their peer group. 

 TSP participants have similar allocations to bond funds, however significantly more in stable 

value than their peer group. 

 TSP participants have a higher allocation to target date/life cycle funds than their peer group. 

The table below shows the asset allocation practices according to Vanguard 2011 survey.

2011 Vanguard Survey: Participant Asset Allocation 

Vanguard Plan 

Assets 

Allocations 

Excluding Company 

Stock 

TSP 

Cash Equivalents 

Bond 

16% 

9 

18% 

10 

43% 

8 

Total Fixed Income 25 28 51 

Company Stock 

Diversified Stock 

10 

43 

-- 

48 

-- 

35 

Total Equity 53 48 35 

Balanced 

Target Date/Lifecycle 

Funds 

10 

12 

11 

13 

-- 

14 

TOTAL 100% 100% 100% 

Source: Vanguard 2011
REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

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Observations

 TSP participants have similar allocations to bond and target date funds as their peers. 

 Even when excluding allocations to company stock, TSP participants still have significantly less 

exposure to equities when compared to its peers. 

 TSP participants have the highest allocation to the lowest risk, stable value fund option. 

The graph below shows the 20 year historical risk/return relationship characteristics of the TSP’s 

current investment options. Returns are shown on the Y-axis (annualized return) and risk 

(annualized standard deviation of return) is shown on the X-axis. The L Funds (target date funds) 

were introduced in August of 2005 and consist of varying proportions of the G, F, C, S, and I 

Funds. The historical risk/return characteristics of each L Fund are determined by the component 

weights for each fund. As shown, the investment funds currently offered to participants span the 

risk/return spectrum from conservative to more aggressive risk. 

Summary 

TSP participants are offered broad exposure to major asset classes within the five core investment 

options that span the risk spectrum. The L Funds deliver the choice of pre-mixed portfolios that offer 

participants well diversified portfolios with automatic rebalancing that provides a glide path to higher 

fixed income allocations (lower risk portfolios), as the participant’s time horizon shortens. The 

investment options are provided through low-cost, passively managed funds. 

Relative to peers, the TSP offers fewer choices; however, our review of the program leads us to the 

conclusion that there are no major gaps within the core investment options. However, there are 

areas within the broader equity universe that are not represented in the core options (small cap 

international and emerging markets) that may provide better risk adjusted returns when included as 

part of the broader equity exposure. We also believe it will be worthwhile reviewing additional asset 

Efficient Frontier -- Based on 20 Years of Historical Data Ending 12/31/12

G Fund

F Fund

C Fund

S Fund

I Fund

T-Bills

0%

2%

4%

6%

8%

10%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Annualized Risk

Expected Geometric Return
REVIEW OF CURRENT CIRCUMSTANCES AND COMPARISON TO PEERS 

 17

classes that may provide participants with better flexibility and that may increase the benefits of 

diversification. 

Having discussed TSP’s circumstances and how it compares to peers, we now review the factors that 

impact participant behavior and our thoughts on how to best implement an investment option 

structure from a “macro” perspective. 
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INVESTMENT STRUCTURE 
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INVESTMENT STRUCTURE 

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Investment Structure 

The investment structure of a participant-directed defined contribution plan refers to the number and 

type of options offered to participants. This is the most important component of the investment 

program. It will not only determine the structure of investment options offered to participants, but will 

also: 

 Shape how participants invest their assets 

 Impact the participants’ perceived value of the Plan 

We believe a plan’s investment options should offer a sufficient range of choice to allow participants 

to form well-diversified portfolios, given a reasonable range of risk and return circumstances. As 

such, we recommend that the TSP have a structure that: 

 Offers sufficient range of choice – with options that span the risk and return spectrum 

 Allows participants to form well-diversified portfolios 

 Meets broad participant demand 

 Is appropriately comparable with peers 

We recommend that at a minimum the TSP offer the investment option types listed below. The 

investment option types provide representation of all major asset classes typically considered suitable 

for defined contribution plans, represent the major building blocks for a diversified portfolio, and allow 

for representation of different levels of risk: 

 U.S. stock 

 Non-U.S. stock 

 Diversified fixed income 

 Cash equivalent/stable value 

 Lifecycle 

The TSP currently offers at least one broadly diversified “core” investment fund in each of these 

categories. 

We generally recommend offering only a single option in the cash equivalent/stable value, diversified 

fixed income and international stock categories, as one option is all that is necessary to provide the 

asset class exposure required to diversify participant portfolios. However, it is common practice to 

provide two options for international stock (developed and emerging markets). In general, we would 

not recommend offering an emerging market equity fund on a standalone basis for most DC plans, 

but especially for a plan such as the TSP, given the higher volatility of the asset class. 
INVESTMENT STRUCTURE 

 22

 

The two categories where it is appropriate to consider multiple options are lifecycle and U.S. stock. It 

is appropriate to offer multiple lifecycle funds as a program must meet the needs of participants with 

materially different time horizons (e.g., 5 years vs. 35 years). 

Offering multiple options in U.S. stock is appropriate for the following reasons:

 Participants’ knowledge of U.S. stock investing has grown tremendously in recent years – 

resulting in increased demand for U.S. stock fund alternatives. 

 As U.S. stock is generally one of the largest components of a participant’s portfolio, a subset of 

participants typically want to customize their defined contribution plan U.S. stock portfolios to 

account for personal (taxable and tax-exempt) investments, complement investment funds 

available in a spouse’s plan and/or account for their own investment preferences/risk tolerance. 

 It represents contemporary practice, in part, due to the fact that small cap stocks have different 

risk and return attributes relative large cap stocks. 

The types of U.S. stock funds that are commonly offered across DC are: 

 Core stock index fund 

 Larger-cap value 

 Larger-cap growth 

 Mid/small-cap stock 

The TSP does not offer separate large-cap growth and value fund options. We note, however, that 

participants have access to the entire U.S. stock market, including growth and value stocks, via the C 

and S Funds. 

Actively managed U.S. and non-U.S. stock funds are offered in the majority of plans. The TSP has 

not offered actively managed stock funds as it has not been allowed to do so by statute. It is not 

necessary for the TSP to offer actively managed stock funds as the TSP has provided broad 

exposure to the U.S. and non-U.S. stock asset class via the C, S & I Funds. 

Offering a single option in international stock is appropriate given that it represents contemporary 

practice; typically, managers of non U.S. investments have not focused on growth/value or 

large/small divisions when crafting investment products. A vast majority of defined contribution plans 

offer broad-based non-U.S./international stock funds as opposed to style or capitalization specific 

funds. 
INVESTMENT STRUCTURE 

 23

Guiding Principles 

There are three guiding principles we recommend our clients generally employ in structuring their 

investment fund line-ups. These guiding principles are: 

 Employee education is one of the most important components of a participant-directed defined 

contribution plan. Therefore, the less complex the program is, the higher the likelihood of a 

successful education program, as participants tend to get overwhelmed if there are too many 

options 

 The more broadly diversified an asset class, asset category, investment style, etc., the better it 

will serve participants, in order to avoid non-systematic risk 

 The investment options of an investment program should be structured/communicated to 

participants so they have two paths from which to choose – an array of pre-mixed lifecycle funds 

and an array of broadly diversified asset class/category specific funds 

Number of options: Surveys and studies by providers such as, Fidelity and Vanguard, and 

academics cite that the greater number of options offered, generally the lower a plan’s participation 

rate and/or the fewer number of investment funds utilized. The unintended consequence of offering 

too many funds to participants is that instead of selecting the appropriate fund(s) they become 

overwhelmed and delay their decision to participate. In many cases, they end up not participating at 

all, or make no investment decision and are mapped to the plan’s default fund. 

Broadly Diversified Funds: We generally recommend our clients offer participants investment funds 

that are broadly diversified by security, sector, industry, etc. This assists in avoiding large losses due 

to an undue concentration in a sector, industry and/or security and assists participants in building 

broadly diversified portfolios. 

Tiering of Investment Options: We recommend that clients communicate their lifecycle and asset 

class/category funds as different decision paths or “tiers”. The first path, or tier, is populated with 

lifecycle funds and is intended for participants uncomfortable in or not inclined to making investment 

decisions. Participants are able to then focus on the lifecycle fund that best suits their time horizon. 

The second tier is comprised of the asset class/category specific funds where participants are able to 

select and mix funds in order to build portfolios that best suit their needs. 

Summary 

For the most part, the TSP’s current practices are reflective of our general advice on how to best 

structure a participant-directed defined contribution plan. The investment options are well-diversified, 

the number of options offered in each category are sufficient to gain broad exposure, and participants 

have two “paths” or “tiers” to select from when making their investment decisions. 
INVESTMENT STRUCTURE 

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KEY EVALUATION CRITERIA FOR INVESTMENT FUND ALTERNATIVES
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KEY EVALUATION CRITERIA FOR INVESTMENT FUND ALTERNATIVES 

 27

In this section of the report, we discuss the key criteria we use to evaluate whether or not an asset 

class or asset category should be considered as an investment fund for inclusion in the Thrift Savings 

Plan (TSP). We use these criteria to narrow the asset classes/categories that we review in-depth as 

potential alternatives. 

Evaluation Criteria 

While there are numerous criteria to consider when evaluating the types of investment alternatives to 

offer in a participant-directed defined contribution plan, we believe the following criteria (individually 

and collectively) are among the most relevant for the TSP to consider: 

 Major diversified asset classes/categories not currently offered as an investment option 

 Asset class/category is large enough for the TSP to invest in 

 Potential diversification benefit for TSP participant portfolios 

 Index fund products are available for TSP use 

 Daily valuation 

 Practices of peers 

We discuss these criteria in more detail below. 

Major Diversified Asset Classes/Categories Not Currently Offered to Participants 

We believe it is worthwhile to consider the major diversified capital markets that are not currently 

offered to TSP participants. The TSP currently provides participants the ability to invest in three of the 

world’s largest capital markets (U.S. stock, U.S. bonds and non-U.S. developed markets stock), but 

not all (e.g., non-dollar denominated debt or emerging market stock). For the major diversified asset 

classes not currently offered to participants, we believe reviewing the rationale why such an asset 

class/category would or would not be an appropriate asset class/category to add as an investment 

option is prudent. 

Our review takes into account the advantages and disadvantages of offering an asset class/category 

individually as well as how it could potentially allow participants to form improved portfolios. 
KEY EVALUATION CRITERIA FOR INVESTMENT FUND ALTERNATIVES 

 28

Asset Class/Category is Large Enough for the TSP to Invest In 

Given the extraordinary asset size of the TSP, any investment alternative offered should represent an 

asset class/category of such significance that the likelihood of the TSP becoming a disproportionately 

large investor and trader of the asset class/category is minimized. Several of the measures we 

evaluate are: 

 Size of the asset class/category in terms of market capitalization 

 Liquidity of the market/category 

 Sector diversification within the asset class/category 

 Number of securities that comprise the market /category 

The criteria we will use within this category include: 

Large Capital Market: We define a large capital market by its total market capitalization (the 

aggregate value of the securities that comprise the asset class/category). We believe the appropriate 

threshold to use for the TSP is a minimum market capitalization of $1 trillion. This is an important 

consideration as the extraordinary asset size of the TSP ($330 billion and growing) could cause it to 

own a large portion of a market that is less than $1 trillion in asset size if participants were to allocate 

just 10% of the Plan’s assets to a smaller-sized asset class/category. Moreover, the fact that the TSP 

offers daily liquidity to its participants and participants have transferred substantial assets into and out 

of its options (e.g., $700 million in a single day and $1.5 billion in six consecutive business days) 

implies that TSP participants could trade an abnormally large amount of a small market in a single 

day and significantly impact prices. The market capitalization of each of the benchmarks for the TSP 

Funds exceeds $2.5 trillion. 

F Fund C Fund S Fund I Fund 

Fund benchmark Barclays 

Aggregate Bond 

Index 

S&P 500 Stock 

Index 

Dow Jones 

Wilshire 4500 

Index 

Morgan Stanley 

Capital 

International 

(MSCI) Europe, 

Australasia, and 

Far East Stock 

Index 

Market 

capitalization of 

benchmark 

$16.8 trillion $12.3 trillion $2.5 trillion $10.9 trillion 

Number of 

securities 

8,000+ 500 4,400+ 900+ 
KEY EVALUATION CRITERIA FOR INVESTMENT FUND ALTERNATIVES 

 29

Liquidity 

We place significant emphasis on liquidity of a potential fund offering, given the need to ensure daily 

liquidity to participants and to ensure that all participant directed trading activity is met. For existing 

TSP fund options, liquidity is not a major issue given the large underlying market represent by each 

fund mandate’s opportunity set. 

Some markets/sectors may not be able to absorb large trades without impacting prices in a direction 

that is adverse to participants. If there is excessive demand to buy a stock relative to its supply, it will 

drive the price of the stock higher temporarily, and vice versa, resulting in a “buy high, sell low” 

outcome. Trades that constitute a large portion of the average daily volume (ADV) can be expensive; 

investment managers and traders typically avoid representing more than 10%, and at most 20% of 

the ADV in any security. While markets/sectors, per se, may be liquid, they may not be liquid enough 

for very large trades, such as those experienced by some of the TSP Funds. Liquidity of markets is 

more relevant and important to the TSP than to almost any other defined contribution plan. Based on 

an analysis of daily participant trading activity, we note that in times of market stress the TSP funds 

have significantly large cash flows resulting from participant trading activity both on a daily basis and 

in terms of the aggregate cash flows resulting from trading over consecutive days. Given the size of 

the TSP, these cash flows can represent a significant portion of the daily market liquidity, which could 

pose a challenge in meeting participant trading activity as needed and on a low-cost basis. 

Sector/Security Diversification 

As we discussed earlier, we believe it is important for defined contribution plans to offer broadly 

diversified investment options to participants so as to potentially limit the impact of large losses on 

their portfolios. One way to avoid overly concentrated portfolios is to offer options that are diversified 

by sector, industry and security. Asset classes/categories that are comprised of numerous sectors, 

industries and securities assist in minimizing large losses as the performance drivers of these 

sectors, industries and securities are different or diversified. 

Index fund products are available for TSP use

We review the availability of index fund strategies that offer daily valuation within the asset 

class/category. This is a relevant criterion as the TSP has historically only offered index products and 

any product that the TSP may offer needs to offer daily liquidity so that it integrates easily with the 

plan administration. As discussed in this report, some asset classes/categories do not offer daily 

valued products or a very limited set of daily valued products, and/or no daily valued index product is 

currently available. 

Diversification Benefit 

We also review the potential “diversification benefit” that adding an asset class/category could offer 

participant portfolios. The diversification benefit is the risk reduction and/or return enhancement an 

asset class/category could provide by adding it to portfolios at various risk levels. 
KEY EVALUATION CRITERIA FOR INVESTMENT FUND ALTERNATIVES 

 30

Asset classes/categories that benefit portfolios generally have low correlations relative to the 

investment funds currently offered and competitive historical and expected risk-return characteristics. 

Practices of Peers 

In making decisions about the number and type of investment options to offer in a participant-directed 

defined contribution plan, it is worthwhile to be aware of contemporary practices. This serves as a 

guide as participants will likely compare the type of options offered in their plan to those of their 

spouse, friends, and neighbors. 

This does not mean that the TSP should be compelled to offer funds just because peer plans offer 

certain fund types. Rather the types of options to consider should represent a diversified opportunity 

set that may provide participants exposures not currently available and allow them to form better 

portfolios. 

As we discussed earlier in this report, the TSP offers the types of options that are found in the 

majority of defined contribution plans and the allocations of TSP’s participants to “core” investment 

options is comparable to that of peers. 

Asset Classes/Asset Categories Under Consideration 

Based on the criteria we’ve outlined, we segregate the asset classes/categories that we will review 

into: 

 Broad asset classes/categories not currently offered to TSP participants 

 Asset classes/categories that TSP participants have exposure to via the current investment 

options, but not as a separate fund option 

 Specialty categories that do not fall under the first two categories 

The broad asset classes/categories currently not available to participants in any way that we will 

review are:

 Non-U.S. bonds 

 High yield bonds 

 Emerging market stock 

 Non-U.S. small-cap stock 

 Real estate (private market) 

 Private equity 

 Commodities 

 Emerging market debt 

 Frontier market stock 

 Hedge funds 
KEY EVALUATION CRITERIA FOR INVESTMENT FUND ALTERNATIVES 

 31

The asset classes/categories that are not explicitly offered to TSP participants currently, but 

participants obtain some exposure to via the current investment options offered are: 

 U.S. value stock 

 U.S. growth stock 

 Global REITs 

 Infrastructure 

 Socially Responsible Investment (SRI) funds 
 32

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 33

APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 
 34

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APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 35

In this section of the report, we apply the criteria developed to the asset classes/categories identified 

in Section 4 of our report. 

Application of Criteria 

In determining the asset classes/categories that the TSP should consider as potential additions to its 

array of investment funds offered to participants, we first conduct a broad scope review of the 

possible additions. The purpose of the initial broad scope review is to determine which asset 

classes/categories are worthwhile to review in-depth and those asset classes/categories that should 

be eliminated early on in the process. Factors considered included whether: 

 The asset class/category benefits participants’ portfolios meaningfully 

 The asset class/category has a small market capitalization 

 The class/category is unduly concentrated 

 Daily-valued index products are not available 

 It is a common investment option among peer plans 

The asset classes/categories we initially review are: 

Equities Fixed Income Alternatives/Other 

U.S. Growth Stock Non-U.S. Bonds Private Real Estate 

U.S. Value Stock High Yield Bonds Private Equity 

Global REITs TIPS Commodities 

Emerging Market Stock Emerging Market Debt Hedge Funds 

Non-U.S. Small-cap Stock Socially Responsible/ 

Frontier Markets Corporate Governance Funds 

 Infrastructure 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

Screening Criteria: U.S. Stock, Global REITs and Non-U.S. Stock Asset class/asset category 

Current 

Investment 

Fund provides 

exposure to: 

Large market 

capitalization 

>$1 trillion 

Diversified by 

sector, industry 

and/or 

securities 

Liquid market Meaningful 

portfolio 

diversifier: 

correlation of 

<0.5 relative to 

current TSP 

stock funds* 

Daily value

index produc

available 

U.S. Growth Equities Yes Yes ($6 trillion) Yes Yes No Yes U.S. Value Equities Yes Yes ($6 trillion) Yes Yes No Yes Public Real Estate/ Global REITs 

Yes; 2% of C, 6% 

of S and 2% of I 

Funds 

Yes ($1 trillion) 

Yes – security 

Yes – industry 

No - sector 

Yes; but may be an 

issue for TSP if cash 

flows exceed $100 

million 

Yes Yes 

Emerging Markets 

No Yes ($4 trillion) Yes 

Yes, but may be an 

issue for TSP if cash 

flows exceed $100 

million in a day 

No, moderate 

benefit as 

correlations to C, 

S and I Funds 

are <0.8 

Yes 

Non-U.S. SmallCap 

No Yes ($2 trillion) Yes 

Yes, but may be an 

issue for TSP if cash 

flows exceed $100 

million in a day 

No, moderate 

benefit as 

correlations to C, 

S and I Funds 

are <0.8 

Yes 

Frontier Markets 

No No; Approx. $100 

billion 

No – security 

No – industry 

No -- sector 

No Yes 

Yes; 2 provid

(Blackrock

Claymore/BN

*See appendix for complete correlation matrix 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

Screening Criteria: Fixed Income Asset class/asset category 

Current 

Investment Fund 

provides 

exposure to 

Large market 

capitalization 

>$1 trillion 

Diversified by 

sector, industry 

and/or securities 

Liquid market Meaningful 

portfolio 

diversifier: 

correlation of 

<0.5 to current 

TSP bond funds* 

Daily valued 

product is a

Non-U.S. Bond No Yes ($21 trillion) Yes Yes No Yes Emerging Market Debt 

No Yes ($9 trillion) Yes Yes Yes Yes; 2 prov

(Blackrock, 

High Yield No Yes; Just over $1 

trillion 

Diversified, but 

has been 

concentrated in 

certain sectors 

and securities 

historically 

 Yes, but may be 

an issue for TSP if 

cash flows exceed 

$100 million in a 

day 

Yes Yes 

TIPS No No; Just under $1 

trillion 

No; not a major 

issue as securities 

are backed by the 

full faith and credit 

of the U.S. 

government 

 Yes, but may be 

an issue for TSP if 

cash flows exceed 

$100 million in a 

day 

No; high 

correlation to F 

Fund 

Yes 

*See appendix for complete correlation matrix
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

Screening Criteria: Real Estate, Private Equity and Alternatives/Other Asset class/asset category 

Current 

Investment 

Fund provides 

exposure to 

Large market 

capitalization: 

>$1 trillion 

Diversified by 

sector, industry 

and/or 

securities 

Liquid market Portfolio 

diversifier: 

correlation to 

current funds is 

<0.5* 

Daily valu

index prod

is availab

Private Real Estate 

No Yes (>$12 trillion) 

Yes – security 

Yes – industry 

No - sector 

No 

Yes; due to its 

appraisal based 

valuations 

No 

Private Equity 

No Yes ($2 trillion) Yes No 

Not applicable; 

appraisal based 

valuations made 

No 

Commodities 

No 

Yes via futures 

instruments 

Yes 

Yes; most 

futures markets 

are liquid 

Yes Yes 

Hedge Funds No; active 

management 

strategy 

Not applicable; 

not an asset 

class 

Not applicable; 

not an asset 

class 

No; most 

vehicles allow 

limited liquidity 

Not applicable; 

not an asset 

class per se 

No 

Socially Responsible Investing/Corporate Governance 

Yes; Within C, S, 

& I Funds Yes ($6 trillion) Yes Yes 

No; High 

correlation to C, 

S & I Funds 

Yes 

Publicly Traded Infrastructure (Equities) 

Yes; Within C, S, 

& I Funds Yes ($1 trillion) 

Yes – Security 

No – Industry 

No – Sector 

Yes 

No; High 

correlation to C, 

S & I Funds 

Yes; 2 provid

(Blackrock 

SSgA) 

*See appendix for complete correlation matrix While index funds are offered across some of the categories noted above, it is important to note that the size of passive offering

large and/or products/strategies may not be available from multiple providers. Those factors, in addition to others, may preclud

competitive bids from fund providers. Moreover, were the TSP to offer an option to some of the categories listed, it is conceivab
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

could easily represent more than 50% of the major index fund providers’ assets under management in that category and in som

as two times providers’ assets under management .
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 40

Below we discuss the information provided in the tables on the previous pages and provide our 

rationale why we believe an asset class/category should or should not be further considered as an 

investment fund option. In sections 6 to 11 of this report we provide an in-depth review of the asset 

classes/categories we believe are worthwhile to examine in detail. 

U.S. Stock 

We review investment fund alternatives in U.S. stock by style (value and growth). 

We highlight our rationale for reviewing U.S. stock investment funds by valuation below: 

 Larger-cap growth and value market segments are substantial with over $12 trillion market 

capitalizations, respectively 

 The market segments are diversified by sector, industry, and securities 

 Index products from the major index providers are available 

 These market segments are liquid 

 Peer practice: a majority of plans offer large-cap growth and value fund options to participants 

 Allows participants to better customize their TSP portfolio so that it complements their “total 

portfolio” – i.e., taxable investments, non-TSP retirement investments and spouse’s assets – to 

better suit their circumstances 

We do not review small cap value and growth funds. As each of these markets is relatively small 

(approximately $1 trillion in market capitalization), the TSP could face liquidity issues if cash flows 

exceed $200 million in a day. Participants have access to these segments via the S Fund, and the 

amount of assets indexed in this category is modest. 

We discuss the merits of offering large-cap growth and value funds in Section 7. 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 41

Global REITs 

We review the merits of adding Global REITs as an investment option.

We review REITs as a potential investment fund alternative for the following reasons: 

 REITs have relatively low correlations to the current TSP Funds 

 REITs have grown substantially in market capitalization in recent years 

 The major index providers offer REIT index funds 

 Some investors argue that REITs are a hedge against inflation 

 REITs are beginning to be offered as investment options in DC plans 

We address Global REITs in Section 10 of this report. 

Non-U.S. Stock 

We review the merits of offering an emerging markets stock fund. 

We review the merits of offering a non-U.S. small-capitalization stock fund. 

We eliminate a frontier markets stock fund from further consideration. 

As the I Fund is a large- to mid-cap diversified non-U.S. developed markets index fund, we review 

two potential additions to the TSP investment line-up, emerging markets stock and non-U.S. smallcap stock. 

Emerging Markets 

We believe it is appropriate to review the merits of an emerging markets stock fund for the 

following reasons: 

 Large market with total capitalization of over $4.0 trillion (approximately 15% of world equity 

market capitalization) 

 Emerging markets are diversified by country, sector, industry, and securities 

 TSP participants do not currently have exposure to emerging markets 

 Daily valued index products are available 

 Expectations are that emerging markets will provide exposure to some of the world’s most rapidly 

expanding economies. Emerging markets now account for over 40% of world GDP. 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 42

There are a number of issues that warrant further discussion regarding the risks of offering an 

emerging markets stock fund, which include volatility of returns, market liquidity, political risk and that 

the majority of peer plans do not offer this fund type. We discuss the merits of adding an emerging 

markets stock fund in Section 8. 

Non-U.S. Small-cap Stock 

We believe it is appropriate to further review the merits of adding a non-U.S. small-cap stock 

fund, for the following reasons: 

 Market capitalization of nearly $2.0 trillion 

 Daily valued non-U.S. small-cap stock index funds are offered by major index providers 

 Modest diversification benefits 

 Investor’s are realizing the importance of diversification through international equities and as a 

result, thinking should be consistent with the U.S. market options. 

We discuss the merits of offering a non-US small cap option in Section 12 of this report. 

Frontier Markets Stock

We eliminate a frontier market stock fund from further consideration for the following reasons: 

 Small market size of only $100 billion 

 Concentrated exposures (stock, industry and sector) 

 Frontier market stock funds are not common practice among peers 

Fixed Income 

We review in-depth the merits of adding a non-U.S. bond fund and an emerging market debt fund. 

We eliminate TIPS and high yield bond funds from further consideration. 

Non-U.S. Bond 

We believe it is appropriate to further review non-U.S. bonds for the following reasons: 

 Large market: non-U.S. bonds represent approximately 20% of the world’s market capitalization 

at nearly $21.0 trillion 

 TSP participants do not currently have any exposure to this substantial asset class 

 Non-U.S. bond market is well-diversified by country, maturity and issuers 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 43

 Non-U.S. bonds have a low correlation to stocks and the unhedged funds have low correlations to 

traditional bonds 

We discuss the merits of offering a non-U.S. bond fund in Section 6. 

Emerging Market Debt 

We believe it is appropriate to further consider emerging market debt for the following 

reasons: 

 Large and rapidly growing market with current market capitalization of $1.7 trillion 

 Emerging markets have seen improvements relative developed markets in recent years 

– Higher GDP growth relative to developed markets 

– More stable financial condition from large currency reserves and lower public debt than 

developed countries 

– Improved credit ratings relative developed market bonds 

– Higher yields relative developed markets 

 Diversification benefits with low correlation to traditional bond and equity markets 

 Daily valued, index funds are available from major index providers. BlackRock is the largest 

index fund provider at nearly $8 billion under management. 

We review the merits of offering an emerging market debt fund in Section 11 of this report. 

TIPS 

We do not believe TIPS warrant further consideration for the following reasons. 

 The size of the market is just under $1.0 trillion. 

 TIPS are an attractive asset class for investors who seek to hedge against inflation, but the TSP 

offers a fund (G Fund) that provides similar characteristics, over the long-term, without negative 

price volatility associated with a TIPS option. 

 TIPS are a good hedge against inflation, if they are held to maturity. Over shorter periods, 

however, TIPS may not yield a return comparable with inflation since the prices at which the 

bonds may be traded may not perfectly sync with inflation over a given holding period. 

 TIPS fund would provide limited diversification benefits to TSP participants and add complexity to 

the plan lined-up in area where we do not believe additional flexibility is necessary given the G 

Fund offering. 

 Not common practice among peers to offer TIPS funds. 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 44

High Yield Bonds 

We do not believe high yield bonds warrant further consideration for the following reasons: 

 While the high yield market is relatively large at $1 trillion, the market has been concentrated in 

certain industries over time (casinos, cable, autos). 

 Composition of market is driven by issuers – i.e., the high yield market’s composition is not 

necessarily a result of demand by investors as the market’s composition may result from 

sector/industry issuance and/or downgrading of former investment-grade issuers (e.g., Ford) 

 Replicating a broadly diversified high yield bond index is very difficult without incurring high 

tracking error; Only a highly liquid sub-set can be indexed successfully, however that dilutes 

some of the diversification benefit 

 High yield bond funds are not common practice among peers 

Private Market Real Estate 

We eliminate private market real estate from consideration. 

While we generally advocate that our defined benefit plan clients invest in real estate, we eliminate 

private market real estate from further consideration. Daily valued direct real estate products are now 

being offered to defined contribution plans, usually as a sleeve of their target date funds. These 

funds are typically invested in 1/3 REITs and cash and 3/4 direct real estate to provide daily liquidity. 

There is a movement in the industry to provide a single real estate asset class that provides exposure 

to both REITs and direct real estate investments. However, these funds are still fairly small and are 

limited to target date funds.

Private Equity 

We eliminate private equity from further consideration. 

Private equity is broadly defined as venture capital, leveraged buyouts, mezzanine financing, 

distressed debt and special situations. We eliminate private equity from further consideration for the 

following reasons: 

 Private equity investment vehicles are illiquid, and the assets are valued infrequently - a major 

issue for TSP administration 

 No daily valued index product currently exists 

 Private equity investments cannot be passively managed 

 Private equity represents a small proportion of the world’s overall market capitalization 

 Private equity is not a common investment type offered to participants 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 45

Hedge Funds 

We eliminate hedge funds from further consideration. 

While hedge funds have garnered billions of dollars in assets over the past several years, we 

recommend eliminating hedge funds from further consideration for the following reasons: 

 The hedge fund category is not an asset class in and of itself; rather hedge funds represent a 

broad array of active management strategies 

 No daily valued index fund of hedge funds exists 

 The majority of hedge funds do not offer daily liquidity 

 Hedge funds are not a common investment offering in peer plans 

Commodities

We evaluate the merits of offering commodities as an investment option. 

We believe it is worthwhile to review commodities as a potential investment option for the following 

reasons: 

 No explicit exposure via current TSP offerings 

 Diversified among different types of commodities (e.g., oil, metals, grains) 

 Commodities can be a strong portfolio diversifier 

 Commodities have shown to be a strong hedge against inflation 

 Large and liquid market 

We discuss the merits of adding a commodities fund in Section 10 of this report. 

Socially Responsible/Corporate Governance Funds (Equities) 

We eliminate socially responsible investment (SRI) stock funds from further consideration. 

While SRI investing has gained in popularity over the years and several of the large public sector 

plans provide this option, we eliminated SRI from further consideration for the following reasons: 

 SRI is a style of investing that can be implemented passively, but the selection of the SRI issue(s) 

is an active decision to exclude or include a security/company – an approach the TSP has not 

employed previously 
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 46

 Identification of an issue(s) would likely draw attention from opposing parties of interest – i.e., 

difficult to find “perfect” common ground 

 Exposure to equities found in socially responsible funds can be found in the C, S, & I Funds 

While defined contribution plan participants often express an interest in an SRI fund option, our 

research and experience indicates that an SRI option is not widely offered across the broad spectrum 

of DC plans (including private sector DC plans). Where an SRI option is offered, we find participant 

utilization to be low. 

One explanation of the discrepancy between the apparent participant demand and actual plan 

sponsor/participant practices is expressed in a study that was conducted by Hartford Financial 

Services Group in 2004. It notes that “91 percent of defined contribution plan participants would be 

interested in funds managed by a socially responsible firm as long as the funds boasted top historical 

performance.” 

Some of the issues noted above were also reflected in a study conducted by the Government 

Accountability Office (GAO) titled “Thrift Savings Plan – Adding a Socially Responsible Index Fund 

Presents Challeneges”. 

The following is the conclusion from that report: 

Adoption of an SRI index fund would present challenges for TSP. Currently, the law limits the types of 

funds that TSP can offer, prohibits overlap among existing funds, and charges TSP to keep its costs 

low. First, TSP would have difficulty finding an SRI index fund that did not overlap with the existing 

TSP funds, limiting opportunities for additional portfolio diversification. However, officials at other DC 

plans, which do not face the same restrictions as TSP, said that a certain amount of overlap with SRI 

and other investment options was acceptable and the purpose of SRI was to provide an alternative 

investment choice. Second, TSP would have difficulty selecting SRI screening criteria that all 

participants and the Congress would find acceptable. While challenging, a number of plans have a 

long history of SRI in their plans. Finally, under TSP’s current structure, the costs of adding a new 

fund would be distributed among all participants regardless of whether they participated in that fund. 

We note that the Board has the authority to open a mutual fund window for participants to invest in 

mutual funds managed outside TSP. If the Board decides to act on this authority and allow the mutual 

fund window, participants seeking other forms of investment, including SRI, could invest in mutual 

funds and would bear the costs associated with this investment.
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 47

Publicly Traded Infrastructure Funds (Equities) 

We eliminate publicly traded infrastructure funds from further consideration. 

Background: The broad infrastructure space comprises of publicly traded equities of infrastructure 

and infrastructure-related companies and private infrastructure investments. Private infrastructure 

investments include toll roads, airports, ports, etc. and are offered in fund vehicles similar to private 

equity investments. 

We eliminate private infrastructure from further review because of the lack of a daily valued 

product/strategy in the space and the illiquid nature of this asset class. 

Publicly-traded infrastructure comprises equity of companies that are directly or indirectly related to 

the infrastructure space. Most of these companies are concentrated in the industrials, utilities and 

energy sectors. These may include pipelines, airport services, highways, railroads, ports, electric, gas 

and water utilities. 

The chart below shows the sector concentrations of the S&P Global Infrastructure Index. The S&P 

Global Infrastructure Index is the most commonly used liquid infrastructure index. It has exposures to 

75 companies across 19 countries across the world. The Index provides exposure to three broad 

sectors – energy, industrials, and utilities – as shown in the chart below. The Index is constructed by 

selecting the largest 30 stocks from the Utilities and Transportation Infrastructure segments and the 

largest 15 stocks from the Energy Infrastructure segment. S&P notes that up to 20% of the 

constituents within the Index are emerging market stocks with a liquid developed market listing. The 

Index is somewhat concentrated in that the top ten stocks represent nearly 40% of the Index, as 

compared to the S&P 500 Index where the top ten stocks represent approximately 20% of the overall 

market capitalization. 

 Concentrated exposure to utilities, energy and industrial sectors of the equity market 

 

Industrials

42%

Utilities

38%

Energy

20%
APPLICATION OF KEY CRITERIA TO INVESTMENT FUND ALTERNATIVES 

 48

 Minimal diversification benefits relative the broader equity market 

 Publicly traded infrastructure exposure is approximately 5% of the U.S. and international equity 

markets and, as a result, can be accessed through the C,S, & I Funds 

 Infrastructure is not a commonly offered option to participants 

Summary 

We conduct an in-depth review of the following asset classes/categories in Sections 6 through 12. 

 Non-U.S. bonds 

 U.S. stock funds by valuation 

 Emerging markets stock 

 Global REITs 

 Commodities 

 Non-US small cap stock 

 Emerging market debt 

We eliminate the following asset classes/categories from further consideration: 

 TIPS 

 High yield bonds 

 Private market real estate 

 Private equity 

 Hedge funds 

 Socially responsible/corporate governance funds 

 Frontier markets stock 

 Infrastructure stocks 
 49

NON-U.S. BONDS 
 50

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NON-U.S. BONDS 

 51

We review the merits of offering a non-U.S. bond fund as an investment fund alternative. The primary 

rationale for reviewing non-U.S. bonds includes the significance of non-U.S. bonds in terms of size 

and the fact that it is diversified by security and issuer. We review the asset class in greater detail and 

provide our recommendation as to whether the FRTIB should offer a non-U.S. bond fund.

Market Size 

Non-U.S. bonds comprise over 20% of the world markets (stocks and bonds) with approximately $21 

trillion in assets. As one of the world’s largest capital markets, it is appropriate to review whether or 

not the TSP should offer this asset class as a stand alone investment fund. Below we discuss the 

relevant factors to consider in making this decision, such as historical risk-return characteristics, 

potential diversification benefits and index product availability. Earlier in our report we noted that nonU.S. bond portfolios were not commonly offered in peer plans. 

Historical Performance of Non-U.S. Bonds 

In the table below, we show the historical returns of currency unhedged and currency hedged nonU.S. bonds. We show the returns of the CitiGroup World Government Bond Index (CWGBI) as this is 

the most widely used non-U.S. bond index. We also show the returns of the Barclays Aggregate Bond 

Index (benchmark for the F Fund) for comparative purposes. 

Annualized Returns (As of September 30, 2012) 

Trailing Years

CitiGroup World 

Government 

Bond Index 

(Unhedged)

CitiGroup World 

Government 

Bond Index 

(Hedged)

Barclays 

Aggregate Bond 

Index

1 3.5% 4.9% 5.2% 

3 4.0 3.6 6.2 

5 6.6 4.6 6.5 

10 7.3 4.3 5.3 

15 6.0 5.4 6.2 

20 6.2 6.5 6.3 

The fluctuations in returns between the unhedged CWGBI and the hedged CWGBI are a result of the 

performance of the U.S. dollar relative to foreign currencies. Recent flight to quality, during the 

financial crisis, to US government bonds and exposure to credit helped the Barclays Aggregate Bond 

Index outperform both hedged and unhedged CWBI indexes. 
NON-U.S. BONDS 

 52

The table below shows the volatility (annual standard deviation) of the indexes over several trailing 

periods. 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years 

Citigroup World 

Government 

Bond Index 

(Unhedged) 

Citigroup World 

Government 

Bond Index 

(Hedged) 

Barclays 

Aggregate Bond 

Index 

5 9.4% 2.9% 3.6% 

10 8.6 2.7 3.6 

15 8.6 2.6 3.5 

20 8.3 2.9 3.7 

The higher level of volatility of the CWGBI Unhedged Index is due to foreign currency performance 

relative to the U.S. dollar. 

We show the correlations of the unhedged and hedged CWGBI returns relative to the returns of the 

TSP’s current investment funds in the table below. Correlation coefficients can range from +1 to -1. A 

correlation of +1 between two indexes implies that the returns of the two indexes move in the same 

direction and in the same proportion, while a correlation of -1 means that the returns move in opposite 

directions but in the same proportion. Low to negative correlations generally imply a risk 

diversification benefit. 

Correlations (20 years ending September 30, 2012) 

G Fund F Fund C Fund S Fund I Fund 

CWGBI 

Unhedged

CWGBI 

Hedged 

G Fund 1.00 

F Fund 0.11 1.00 

C Fund 0.03 0.05 1.00 

S Fund -0.02 -0.02 0.85 1.00 

I Fund -0.01 0.03 0.81 0.76 1.00 

CWGBI 

Unhedged 

0.03 0.44 0.10 0.08 0.34 1.00 

CWGBI Hedged 0.24 0.67 -0.08 -0.16 -0.16 0.32 1.00 

The overall low correlations of the hedged and unhedged CWGBI to the C, S and I Funds seem 

appealing at first. However, the F Fund also has low correlations to the C, S and I Funds. Additionally, 

the hedged CWGBI has a reasonably high correlation to the F Fund, where the unhedged CWGBI 

has a moderate correlation with the F Fund, indicating that there may be some diversification benefit 

to be had from adding unhedged non-U.S. bonds. 
NON-U.S. BONDS 

 53

In the following graphs, we show the historical efficient frontier for TSP participants using the current 

TSP investment options and the efficient frontier if the hedged and unhedged CWGBI were part of the 

investment line-up. 

The efficient frontier is the mix of different funds that provides the highest expected return for a given 

level of risk or the asset mix with the lowest level of risk for a given return. 

There is little difference in the historical efficient frontiers for the TSP’s current investment fund and 

those that include unhedged WGBI, however there is a small improvement when hedged WGBI is 

added, particularly, in the low risk portfolios. One must caution relying solely on historical data to 

draw conclusions, as the past may not be indicative of the future. 

The table below shows the amount of assets indexed to non-U.S. bonds by the three largest 

institutional index fund managers, Blackrock, Northern Trust Global Investments (NTGI), and State 

Street Global Advisors (SSgA). 

Most of the assets indexed to the non-U.S. developed market bonds are in the form of exchange 

traded funds (ETFs). 

Non-U.S. Bond Index Fund Products (assets in millions) – All assets 

Blackrock SSgA 

Global Aggregate Bonds $403 0 

Non-US Developed Bonds $664 $2,123 

Efficient Frontier -- Based on 20 Years of Historical Data Ending 9/30/12

S Fund

I Fund

C Fund

G Fund

F Fund

T-Bills

WGBI Unhedged

WGBI Hedged

0%

2%

4%

6%

8%

10%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Annualized Risk

Current Line-Up Adding Hedged WGBI Adding Unhedged WGBI
NON-U.S. BONDS 

 54

Non-U.S. Bond Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock SSgA* 

Global Aggregate Bonds 0 - 

Non-US Developed Bonds 0 - 

*Daily valued DC asset information was not readily available from SSgA 

Considerations 

We generally advocate that our clients offer only one investment fund alternative in the diversified 

fixed income/bond fund category. We advocate simplicity in the bond category as participants 

generally do not allocate significant assets to bond funds and do not obtain material benefits from 

specialized bond funds if they have a broadly diversified portfolio. Additionally, it can be difficult to 

educate participants regarding the drivers of a specialized bond fund’s performance (interest rate 

sensitivity, credit spreads, currency fluctuations, etc.). 

Non-U.S. bond funds are not common practice in peer plans and the addition of non-US bond funds 

has not shown to add material diversification benefits. Only the unhedged non-U.S. bonds offer low 

correlation to traditional fixed income (F Fund), however significant currency risk is introduced which 

has not been compensated for with higher returns, over the past twenty years. 

Conclusion 

While non-U.S. bonds are a material portion of the world’s market capitalization, indexed assets 

under management are small and could be overwhelmed by cash flows from the TSP. The benefits 

of adding a non-U.S. bond option are minimal from an expected risk-return and portfolio 

diversification standpoint for TSP participants. Moreover, adding a non-U.S. bond fund would add 

complexity to a segment of the plan where we believe additional flexibility is not required and/or 

meaningful. As such, we recommend the FRTIB not add a non-U.S. bond fund as an investment fund 

alternative. 
 55

U.S. STOCK
 56

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U.S. STOCK 

 57

Our rationale for reviewing the merits of offering additional broad-based U.S. stock investment funds 

include: 

 Participants’ knowledge of U.S. stock investing has grown tremendously in recent years – 

resulting in increased demand for U.S. stock fund alternatives. 

 As the allocation to U.S. stocks is generally one of the largest components of a participant’s 

portfolio, a subset of participants may desire to customize their defined contribution plan U.S. 

stock portfolios to account for personal (taxable and tax-exempt) investments, complement 

investment funds available in a spouse’s plan and/or account for their own investment 

preferences/risk tolerance. 

 It represents contemporary practice. 

The types of U.S. stock funds that we generally recommend offering are: 

 Core stock index fund 

 Larger-cap value 

 Larger-cap growth 

 Mid-/small-cap stock 

Depending upon a plan’s circumstances, four to eight U.S. stock funds are typically offered to 

participants. The number of options offered is generally influenced by the number of active and 

passive funds offered and how finely each of the categories is defined. More recently, we have seen 

a trend across DC plans simplifying their U.S. stock line-up. Several of our clients today simply offer 

a broad based (all cap, broadly style neutral), active and passive option within their 401(k) plans. 

The TSP plan already offers access to large cap stocks and mid/small cap stocks via the C and S 

Funds, respectively. In this section of the report, we focus our attention on large cap value and growth 

options. 

Growth stocks are generally thought of as those that have a high earnings growth rate, high price-tobook and high price-to-earnings ratios. Value stocks on the other hand are thought of as those that 

have a high dividend yield, low price-to-book and low price-to-earnings ratios. 
U.S. STOCK 

 58

We show the historical returns, volatility (annualized standard deviation) and Sharpe Ratios for the 

Russell 1000 Growth and Value Indexes. We have used the Russell family of U.S. stock indexes as 

these are the most popularly followed style indexes. Russell utilizes two major factors in determining 

whether a stock is a value stock or a growth stock – price-to-book ratio, and the mean long-term 

growth rate obtained from analysts’ estimates. Higher price-to-book ratios would denote growth 

characteristics. 

 

Annualized Returns (As of September 30, 2012) 

Trailing Years

Russell 1000 Growth 

Index

Russell 1000 Value 

Index S&P 500 Index 

1 29.2% 30.9% 30.2% 

3 14.7 11.8 13.2 

5 3.2 -0.9 1.1 

10 8.4 8.2 8.0 

15 3.8 5.5 4.7 

20 7.5 9.3 8.5 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years 

Russell 1000 Growth 

Index 

Russell 1000 Value 

Index S&P 500 Index 

5 19.4% 20.3% 19.1% 

10 15.5 16.0 15.2 

15 18.9 16.3 16.3 

20 17.4 15.0 15.1 

Sharpe Ratio (As of September 30, 2012) 

Trailing Years 

Russell 1000 Growth 

Index 

Russell 1000 Value 

Index S&P 500 Index 

5 0.13 -0.09 0.02 

10 0.42 0.40 0.41 

15 0.05 0.17 0.12 

20 0.25 0.40 0.35 
U.S. STOCK 

 59

We show the correlations of the various capitalization and valuation segments in the following table. 

Correlations (20 years ending September 30, 2012) 

G Fund F Fund C Fund S Fund I Fund 

Russell 

1000 

Growth 

Russell 

1000 

Value 

G Fund 1.00 

F Fund 0.11 1.00 

C Fund 0.03 0.05 1.00 

S Fund -0.02 -0.02 0.85 1.00 

I Fund -0.01 0.03 0.81 0.76 1.00 

Russell 1000 

Growth 

0.01 0.01 0.95 0.88 0.75 1.00 

Russell 1000 Value 0.04 0.07 0.94 0.76 0.78 0.79 1.00 

Observations 

The historical data suggests that approximately a 50/50 mix of growth and value oriented stocks 

produces risk/return characteristics very similar to that of the S&P 500 Index (C Fund). 

While historical data, over the past 20 years indicates value-oriented stocks have had superior 

risk/return characteristics (higher return with less risk), we would caution against coming to 

conclusions based solely on historical returns. Growth and value oriented stocks fall into and out of 

favor depending on the market cycle. Some have argued that a value premium exists, but other 

research indicates that value stocks carry asymmetric risks. Value stocks tend to decline more than 

growth stocks, during times of economic stress, as is evident in the three and five year returns. 

The common practice in the marketplace for plans that offer style specific funds is to offer both value 

and growth funds so complementary styles are offered to participants and they have the flexibility to 

customize their portfolios. 

Index Investment Options 

The table below shows the amount of assets indexed to large-cap value and growth style equities by 

the major institutional index fund managers. 

U.S. Equity Styles Index Fund Products (assets in millions) – All assets 

Blackrock Northern Trust SSgA 

Russell 1000 Growth Index $9,727 $13,515 $5,702 

Russell 1000 Value Index 9,329 12,247 7,130 
U.S. STOCK 

 60

U.S. Equity Styles Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock Northern Trust SSgA 

Russell 1000 Growth Index $2,067 $225 $1,485 

Russell 1000 Value Index 1,553 -- 1,165 

The level of assets currently invested in index funds benchmarked to the Russell 1000 Value and 

Russell 1000 Growth Index is material at near $29 billion for each at Blackrock, Northern Trust and 

SSgA. 

Considerations 

While the broad industry trend is moving in the direction of simplification of the U.S. equity line-up, it 

is still common practice for plans to offer growth- and value-oriented U.S. stock funds, with it being 

more common to offer larger-capitalization growth and value funds than smaller-capitalization growth 

and value funds. Larger-capitalization growth and value funds are attractive alternatives from a 

market size, liquidity, sector and security diversification, and contemporary practice standpoint. The 

diversification benefits, however, would not be material relative to the current investment funds 

already available. We do not believe it is necessary for the TSP to offer any additional U.S. stock 

funds as the C and S Funds provide exposure to the entire U.S. stock market. Offering a more limited 

number of U.S. stock funds without foregoing material improvement in portfolios would be consistent 

with avoiding investment choice overload. 

 

Conclusion 

On balance, we do not find a compelling reason to add additional U.S. stock funds, as the TSP’s 

current investment line-up provides broad exposure to the U.S. stock market via the C and S Funds. 
 61

EMERGING MARKETS STOCKS
 62

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EMERGING MARKETS STOCKS 

 63

We review the merits of offering an emerging markets stock fund as an investment alternative for the 

following reasons: 

 Large market with total capitalization of over $4.0 trillion (approximately 15% of world equity 

market capitalization) 

 Emerging markets are diversified by country, sector, industry, and securities 

 TSP participants do not currently have exposure to emerging markets 

 Daily valued index products are available 

 Expectations are that emerging markets will provide exposure to some of the world’s most rapidly 

expanding economies. Emerging markets now account for over 40% of world GDP. 

While “emerging markets” are a commonly used term in today’s investment world, there isn’t a single 

concise definition for what constitutes an emerging market economy. In general, countries with 

developing economies that have low- to mid-per capita income levels and are experiencing positive 

structural changes to the characteristics of their economic systems can be thought of as emerging 

market economies. These changes include, but are not limited to, deregulation and privatization of 

industry, rationalization of monetary and fiscal policies, elimination of trade barriers, enhancement of 

property rights, etc. In other words, these economies can be thought of as transitional economies – 

ones that aren’t yet perfectly integrated into the global financial system, but making strides to get 

there. 

On the following pages we review the composition of the emerging markets stock index, its historical 

performance and the potential diversification benefits of adding an emerging markets stock fund. 

We use the Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Stock Index, the 

most widely followed emerging markets stock index, to review the characteristics and performance of 

emerging markets stocks. The following exhibits show that emerging markets are diversified by sector 

and country. 

Emerging Market Characteristics (As of December 31, 2012) 

Market Capitalization ($ in millions) $4.3 trillion 

Number of Securities 2,616 

Average market capitalization $1.7 billion 
EMERGING MARKETS STOCKS 

 64

The countries that comprise the MSCI Emerging Markets Stock Index are shown in the table below.

Emerging Market Country Allocation (As of December 31, 2012) 

Country/Region 

% 

Allocation 

 

China 18.3% 

India 6.6 

Indonesia 2.6 

Korea 15.3 

Malaysia 3.5 

Philippines 0.9 

Taiwan 10.6 

Thailand 2.5 

Asia 60.4% 

 

Czech Republic 0.3% 

Egypt 0.3 

Hungary 0.2 

Poland 1.5 

Russia 6.0 

Turkey 2.0 

Morocco 0.1 

Europe & Middle East 10.4% 

Brazil 12.6 

Chile 1.8 

Colombia 1.3 

Mexico 5.2 

Peru 0.6 

Latin America 21.4% 

 

South Africa 7.8% 

Africa 7.8% 

TOTAL 100.0% 

Historical Performance 

In the following chart, we show the annual returns of emerging markets over time. As seen in the 

chart, emerging market investments exhibit a very high degree of variability (volatility) from year to 

year. 
EMERGING MARKETS STOCKS 

 65

We show the annualized returns, volatility and Sharpe Ratios for the MSCI Emerging Markets Stock 

Index in the following tables. 

Annualized Returns (As of September 30, 2012) 

Trailing Years

MSCI Emerging 

Markets Index MSCI EAFE Index

1 16.9% 13.8% 

3 5.6 2.4 

5 -1.3 -4.9 

10 17.0 8.5 

15 7.2 3.5 

20 8.7 5.7 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years 

MSCI Emerging 

Markets Index MSCI EAFE Index 

5 29.6% 23.5% 

10 24.3 18.6 

15 26.0 18.1 

20 24.1 17.1 

Emerging Markets -- Annual Returns

-60%

-40%

-20%

0%

20%

40%

60%

80%

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Year
EMERGING MARKETS STOCKS 

 66

Sharpe Ratio (As of September 30, 2012) 

Trailing Years 

MSCI Emerging 

Markets Index MSCI EAFE Index 

5 -0.07 -0.24 

10 0.63 0.36 

15 0.17 0.04 

20 0.23 0.14 

The table below shows the historical correlations of the MSCI Emerging Markets Stock Index relative 

to the current TSP Funds. 

Correlations (20 years ending September 30, 2012) 

 G Fund F Fund C Fund S Fund I Fund 

MSCI EM 

Index 

G Fund 1.00 

F Fund 0.11 1.00 

C Fund 0.03 0.05 1.00 

S Fund -0.02 -0.02 0.85 1.00 

I Fund -0.01 0.03 0.81 0.76 1.00 

MSCI EM Index -0.08 -0.02 0.73 0.75 0.77 1.00 

Emerging market returns are relatively highly correlated to the C, S and I Fund, reflecting the 

globalized nature of the world economy and uncorrelated to the F and G Funds.

Below we show the efficient frontiers, based on historical data, using the TSP Funds with and without 

emerging markets as an investment fund alternative. 

Efficient Frontier -- Based on 20 Years of Historical Data Ending 9/30/12

S Fund

I Fund

C Fund

G Fund

F Fund

T-Bills

EM Equity

0%

2%

4%

6%

8%

10%

0% 5% 10% 15% 20% 25%

Annualized Risk

Current Line-Up Adding EM Equity
EMERGING MARKETS STOCKS 

 67

As shown, the efficient frontier with emerging markets as an investment fund alternative changes only 

slightly the risk/return profile at low risk levels (under 10% annualized risk). At the highest risk levels, 

the benefit is more pronounced (risk greater than 15%). We believe the improvement in the efficient 

frontier would be of little benefit to the majority of TSP participants as most would not likely construct 

highly risky portfolios. 

The tables below show the amount of assets indexed to emerging market equities by the major 

institutional index fund mangers. 

Emerging Markets Index Fund Products (assets in millions) – All assets 

Blackrock Northern Trust Vanguard SSgA 

MSCI Emerging 

Markets Index $27,674 $16,882 $75,732 $36,134 

Emerging Markets Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock Northern Trust Vanguard SSgA 

MSCI Emerging 

Markets Index $2,236 $12 $1,260 $1,891 

The total assets indexed to emerging market stocks amongst the leading index fund providers are 

substantial at approximately $156 billion. 

 

Considerations 

Emerging markets continue to expand and represents approximately 15% of the world’s equity 

market capitalization. Emerging markets generate over 40% of the world’s GDP. Emerging markets 

have seen improvements in terms of stronger fiscal position and improving credit ratings of emerging 

market economies relative developed markets. These developments coupled with higher expected 

growth rates make compelling case for inclusion. These strong expectations, however, come with 

considerable risk in terms of volatility of returns and political risk that is not typically present in the 

developed markets. This causes us to pause when considering such an option for a defined 

contribution plan, where a participant could potentially put all their assets in a single fund. Emerging 

market funds are not commonly found in peer plans as stand alone investment options. Liquidity 

would be another area of concern. Large cash flows of $300 to $400 million in a single day, which is 

not uncommon in the TSP funds, may be cause for concern from the standpoint of ensuring daily 

liquidity to meet all participant directed trading activity. 

Conclusion 

While emerging markets are a large asset class, expected to experience secular growth, and provide 

a benefit to portfolios at the highest levels of risk, we have concerns with the TSP offering emerging 

markets as a stand alone investment fund. The high risk associated with emerging markets has 

resulted in material losses over relatively short periods of time and is difficult for participants (or for 

any investor) to bear. Additionally, there are limited benefits to adding emerging market equities to 

well-diversified low to moderate risk portfolios. 
EMERGING MARKETS STOCKS 

 68

Overall, we believe the negatives of offering an emerging markets investment fund outweigh the 

positives and recommend an emerging market stock fund not be added as an investment fund 

alternative. However, we believe that exposure to this asset class could be considered as part of a 

broader allocation to international equities through the (I Fund). Several large government plans are 

offering emerging market exposure through broad market index funds that track the MSCI All Country 

World Index – Ex U.S. 

In 2012, as part of the study to evaluate the benchmarks for each of the TSP funds, we examined the 

benefits to expand the I Fund’s mandate to include emerging markets. While the addition of 

emerging markets appeared compelling on several fronts, we did not believe that it was appropriate 

to include emerging markets as part of a broader I Fund mandate at that time, owing primarily to cost 

and liquidity related concerns. 
 69

GLOBAL REITs
 70

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Global REITs 

 71

We review the merits of offering a Global REIT index fund as an investment alternative for the 

following reasons: 

 REITs have relatively low correlations to the current TSP Funds 

 REITs have grown substantially in market capitalization in recent years 

 The major index providers offer REIT index funds 

 Some investors argue that REITs are a hedge against inflation 

 REITs are beginning to be offered as investment options 

Real Estate Investment Trusts, or REITs are specialized companies that own, and in most cases 

operate income generating real estate properties. REITs are listed on most major stock markets and 

can be traded just like shares in any other company. REITs allow smaller investors the ability to share 

in the ownership of large, income generating real estate such as apartments, offices, hotels, and 

shopping centers – essentially allowing smaller investors the ability to diversify their exposure to real 

estate investments through investing in a portfolio of properties rather than an investment in a single 

or few properties. REITs must distribute at least 90% of their taxable income to shareholders 

annually. 

As REITs are publicly traded securities and listed on U.S. and international stock exchanges, REITs 

are included in the major stock market indexes as part of the finance sector, and as such, we 

consider REITs a sub-sector, similar to autos within consumer durables, pharmaceuticals within 

healthcare, or insurance within the finance sector. US REITs represent approximately 2% of the C 

Fund and 6% of the S Fund. International REITs represent approximately 2% of the I Fund. 

The table below shows the composition of the FTSE EPRA/NAREIT Global Index. REITs are 

diversified among many different types of real estate properties.

FTSE EPRA/NAREIT Global Index – Sector Breakdown 

Sector % Allocation 

Retail 24.6% 

Residential 12.1 

Office 11.8 

Diversified 34.5 

Lodging/Resorts 2.5 

Industrial 4.3 

Healthcare 6.4 

Self Storage 2.4 

Industrial/Office Mixed 1.3 
Global REITs 

 72

The table below shows the country breakdown of the FTSE EPRA/NAREIT Index. The U.S.REIT 

market represents approximately 40% of the overall market, as represented by the FTSE 

EPRA/NAREIT Index. 

FTSE EPRA/NAREIT Global Index – Country Breakdown 

Sector % Allocation 

U.S. 39.4% 

Hong Kong 10.3 

Japan 9.6 

Australia 7.1 

Canada 4.7 

U.K. 4.5 

Singapore 4.5 

Other 19.8 

Total 100.0% 

Historical Performance 

We show the historical returns, volatility and Sharpe Ratios for the FTSE EPRA/NAREIT Global Index 

compared to the S&P 500 Index below. 

Annualized Returns (As of September 30, 2012) 

Trailing Years

FTSE EPRA/NAREIT 

Global Index S&P 500 Index S Fund 

1 30.6% 30.2% 16.9% 

3 12.9 13.2 5.6 

5 -2.2 1.1 -1.3 

10 11.8 8.0 17.0 

15 7.0 4.7 7.2 

20 10.1 8.5 8.7 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years 

FTSE EPRA/NAREIT 

Global Index S&P 500 Index S Fund 

5 27.7% 19.1% 19.4% 

10 21.6 15.2 15.5 

15 20.1 16.3 18.9 

20 18.9 15.1 17.4 
Global REITs 

 73

Sharpe Ratios (As of September 30, 2012) 

Trailing Years 

FTSE EPRA/NAREIT 

Global Index S&P 500 Index S Fund 

5 -0.10 0.02 -0.10 

10 0.46 0.41 0.98 

15 0.21 0.12 0.24 

20 0.36 0.35 0.31 

As shown in the tables above, REITs have performed well over longer time periods, relative the S&P 

500 Index. REITs outperformed stocks by +1.6%, over the past twenty years along with a slightly 

higher Sharpe ratio. However, REITs tend to come with more volatility than the broader stock market, 

as there is no diversification benefit due to its exposure to a single sector of the equity market. 

We show the historical correlations of REITs to those of the current TSP investment funds in the table 

below.

Correlations (20 years ending September 30, 2012) 

 G Fund F Fund C Fund S Fund I Fund 

FTSE 

EPRA/ 

NAREIT 

Global 

Index 

G Fund 1.00 

F Fund 0.11 1.00 

C Fund 0.03 0.05 1.00 

S Fund -0.02 -0.02 0.85 1.00 

I Fund -0.01 0.03 0.81 0.76 1.00 

FTSE EPRA/NAREIT 

Index -0.04 0.16 0.70 0.69 0.78 1.00 

As shown in the table above, REITs have had a low correlation to the G & F Funds, but fairly high 

correlation to the C, S, & I Funds. Given that REITs are a sub-set of equities, it is no surprise that the 

correlation to the equity funds is fairly high. 

We show the historical efficient frontiers using the current TSP Funds with and without Global REITs 

as an investment fund alternative. We use the FTSE EPRA/NAREIT Index as a proxy for Global 

REITs. The FTSE EPRA/NAREIT Global Index covers listed REITs in both developed and emerging 

markets. The index is free-float adjusted, screened for liquidity, size and revenue making it suitable 

for use as the basis for index investment products. 
Global REITs 

 74

As shown, there has been a material improvement in the risk/return trade-off, especially in the middle 

to higher risk portfolios (10% risk level or higher) when adding global REITs. Historically high returns 

and moderate correlations to equities had made REITs an attractive addition to the portfolio. 

We show the amount of assets indexed to Global REITs at Blackrock, Northern Trust and SSgA. 

Global REITs Index Fund Products (assets in millions) – All assets 

Blackrock Northern Trust SSgA 

Global REITs $401 $2,144 $544 

Global REITs Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock Northern Trust SSgA 

Global REITs $185 $72 $266 

The three leading institutional index fund providers listed above have in aggregate approximately $3 

billion in assets indexed to the Global REIT indices. 

Considerations 

REITs have gained in popularity in recent years due to their strong performance, low correlation of 

returns to many of the major capital markets, improved liquidity, and overall growth of the REIT 

market. Some studies have argued that REITs have inflation-protection properties. This has caused 

many investors to review whether or not they should have an explicit exposure to REITs. While TSP 

participants invest in REITs through their investments in the C and S Funds, a REIT option would 

allow participants to make a specific above-market allocation to the sector. 

 Efficient Frontier -- Based on 20 Years of Historical Data Ending 9/30/12

S Fund

I Fund

C Fund

G Fund

F Fund

T-Bills

Global REITs

0%

2%

4%

6%

8%

10%

0% 5% 10% 15% 20% 25%

Annualized Risk

Current Line-Up Adding Global REITs
Global REITs 

 75

The number of defined contribution plans offering a REIT option has increased over the years, 

including one of the ten largest government sponsored defined contribution plans. Nearly one in four 

plans now offers a REIT option, however utilization rates remain low. 

Moderate correlations to equity and attractive returns would have made a material improvement in the 

risk/return trade-off of TSP participant portfolios. The global REITs market has grown to over $1 

trillion making it a large enough to consider as a stand alone option. 

Conclusion 

While there appear to be compelling attributes supporting the inclusion of global REITs, we do not 

recommend their inclusion at this time. As noted, TSP participants attain exposure to REITs in 

market capitalization weights via the C, S and I Funds. One of the hallmarks of the TSP is its 

simplicity – i.e. streamlined option line-up, broadly diversified options that form the core building 

blocks for most portfolios. REITs are a specific sector of the global equity market and exhibit a higher 

degree of volatility than the broad equity market. Adding REITs would make the plan line-up more 

complex. While the number of plans offering a REIT option has increased, utilization has remained 

low. According to the PSCA survey, 22% of DC plans with over 5,000 participants offered REIT 

funds, however only 0.2% of total plan asset were invested in REIT funds. Assets under 

management in Global REITs are among the smallest of all of the options we have reviewed and TSP 

cash flows could conceivably overwhelm the funds. Over time, we see this asset class evolving to 

include direct real estate investments, as part of daily valued index funds that are expected to provide 

exposure to assets that are not part of the overall equity market and as a result will be an even better 

diversifier. It may be worthwhile to revisit this asset class in the future as these developments play 

out, but, for the time being, we do not recommend consideration of a REIT option to the line-up. 
 76

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 77

COMMODITIES 
 78

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COMMODITIES 

 79

Over the last decade, investing in commodities has caught the attention of institutional investors. 

Steep declines in equity markets coupled with strong returns from commodities and fears of higher 

inflation, due to large budget deficits, have contributed to this phenomenon. 

Commodities include energy (crude oil, natural gas, etc.), precious metals (gold, silver, etc.), base 

metals (copper, aluminum, etc.), and agricultural products (cattle, soybeans, etc.). Commodities 

provide a strong diversification benefit, as they tend to have low or even negative correlations with 

other asset classes. Investing in commodities is typically achieved using futures contracts, as 

investing in physical commodities is generally not feasible; most investors don’t have the ability to buy 

and store crude oil or grains. 

Futures contracts can be bought by placing a margin deposit with the futures broker. The margin is 

typically a small fraction of the value of the futures contract and is adjusted (marked-to-market) on a 

daily basis depending on the change in the value of the contract. In order to gain exposure to the 

underlying commodity / financial instrument, the investor need only place a fraction of the value of the 

exposure desired in the margin account, implying that purchasing futures contracts on margin 

essentially results in the use of leverage. In order to maintain an un-levered exposure to the 

underlying commodity, an investor can buy the necessary futures contract on margin and place the 

remaining investments in cash or a cash-like instrument. 

As a result, the returns from a long-only un-levered investment in futures contracts can be 

decomposed as follows: 

Spot Return – Return attributable to the change in the price level of the underlying commodity 

represented by the futures contract 

Roll Return – Return associated with “rolling” the futures contract at each contract maturity date. 

Futures contracts have a finite life. In order to maintain continuous exposure to the underlying assets, 

investors need to sell near-dated futures contracts at expiration and buy longer-dated contracts. The 

process of trading the futures to maintain exposure to the underlying commodity is referred to as 

rolling the futures. The roll process can result in either a profit or a loss. 

Collateral Return – The yield on the cash or government bond instrument held as collateral against 

the futures investment. 
COMMODITIES 

 80

The chart below shows the sector breakdown of the Goldman Sachs Commodities Index (GSCI) and 

Dow Jones-UBS Commodity Index, which are the most widely tracked commodities indexes. 

Sectors DJ-UBS GSCI

Energy 31.7% 69.0% 

Agriculture 30.7 15.5 

Industrial Metals 18.8 6.9 

Precious Metals 12.8 3.5 

Livestock 6.0 5.0 

Historical Performance 

We show the historical performance of the Goldman Sachs Commodities Index (GSCI) and Dow 

Jones-UBS Commodity Index, the most widely tracked commodity indexes, below. 

Annualized Returns (As of September 30, 2012) 

Trailing Years DJ-UBS GSCI

1 6.0% 12.7% 

3 5.3 6.5 

5 -3.0 -5.5 

10 5.2 3.4 

15 4.0 2.4 

20 5.5 3.6 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years DJ-UBS GSCI 

5 22.1% 27.9% 

10 18.5 25.2 

15 17.4 24.2 

20 15.5 21.8 

Sharpe Ratios (As of September 30, 2012) 

Trailing Years DJ-UBS GSCI

5 -0.17 -0.22 

10 0.18 0.06 

15 0.07 -0.01 

20 0.15 0.02 

The DJ-UBS Index has been significantly less volatile than the GSCI Index because it has lower 

concentration in the energy sector. Commodities in general have had fairly low Sharpe ratios, due to 

modest returns and high volatility. Given, the high volatility and concentrated nature of the GSCI 

Index, we will eliminate it from further analysis, in the remainder of this section. 
COMMODITIES 

 81

Correlations (20 years ending September 30, 2012) 

 G Fund F Fund C Fund S Fund I Fund DJ-UBS GSCI 

G Fund 1.00 

F Fund 0.11 1.00 

C Fund 0.03 0.05 1.00 

S Fund -0.02 -0.02 0.85 1.00 

I Fund -0.01 0.03 0.81 0.76 1.00 

DJ-UBS 0.05 0.04 0.33 0.35 0.45 1.00 

As shown in the table above, commodities have had very low correlation of returns relative to the 

TSP’s current investment funds. 

Below we show the amount of assets indexed to commodities with the leading index fund providers. 

Commodities Index Fund Products (assets in millions) – All assets 

Blackrock Credit Suisse SSgA Deutsche Bank 

DJ UBS $1,159 $5,500 $502 -- 

GSCI $1,330 -- $6,750 

Commodities Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock Credit Suisse SSgA Deutsche Bank 

DJ UBS $391 -- -- -- 

GSCI -- -- -- $3,375 

Over $15 billion is indexed to the major commodities indexes by the three major index providers of 

commodities. While Credit Suisse and Deutsche Bank are not large providers of a wide range of 

institutional index products, they are the largest commodities index fund providers. Credit Suisse & 

SSgA could not provide the amount that was managed within daily-valued DC assets. 

Based on the last 20 years of historical data, for the DJ-UBS Commodity Index, our optimization 

programs do not recommend adding commodities to existing TSP investment funds. The benefit of 

low correlation to other TSP funds has been offset by low returns and high risk. We must caution 

against using historical performance as the only consideration. Over the last 5 years, poor 

performance of the index has significantly lowered the 20 year return, which is an input into the 

optimization. Had the optimization been performed five years ago, the results would have been 

significantly different with higher commodity returns that would have shown a benefit to the TSP 

program. The chart below shows the rolling five year returns of the DJ-UBS Commodity Index which 

shows current historical commodity returns are near their lows compared to five years ago when they 

were near their highs. We used the DJ-UBS Commodity Index, due to its more diversified allocation 

(less emphasis on energy).
COMMODITIES 

 82

We utilized Hewitt Ennisknupp’s most recent capital market assumptions (forward-looking) to analyze 

whether it would change the results of the optimization. For the TSP funds, we used asset class 

proxies that most closely represent the TSP funds (U.S. large cap, U.S. small cap, international 

developed equity, core bonds and cash). Our forward-looking assumptions have commodity returns 

at low levels (3.8% versus 7.5%.for equities) with comparable risk (21.0% versus 21.5%). Below is 

the efficient frontier using HewittEnnisknupp’s forward-looking capital market assumptions with and 

without commodities. 

 5 Year Rolling Annualized Returns -- DJ-UBS Commodity Index

-10

-5

0

5

10

15

20

Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12

 Efficient Frontier -- Based on 10 Year Forward-Looking Assumptions*

US Small Cap

International Equity

US Large Cap

Cash

Core Bonds

Commodities

0%

2%

4%

6%

8%

10%

0% 5% 10% 15% 20% 25% 30%

Annualized Risk

Current Line-Up Adding Commodities
COMMODITIES 

 83

Even when using forward-looking assumptions, the addition of commodities has very minimal 

improvement on the efficient frontier, over using only the current TSP options. Despite low 

correlations to other assets, the low expected return and high risk offsets those benefits. 

Considerations 

Commodities futures offer a diversification benefit, relative to equities and a potential hedge against 

inflation. We note that spot commodities have actually underperformed both cash and inflation over 

the long term; commodity futures have outperformed because of the roll return and collateral yield. 

Unlike other capital assets such as equities or fixed income securities, commodities do not represent 

the capitalization of a stream of future cash flows. Commodity prices and consequently returns, are 

driven by current and expected supply/demand; we have no means to expect the roll returns of the 

past to continue in the future. To complicate matters, many commodities are trading in contango 

which is where the spot price is cheaper than those expiring in the future. This is important because 

it will have the effect of producing negative roll yield, as more expensive futures are purchased to 

replace expiring ones, in order to maintain exposure. Historically, most commodities traded in 

backwardation which produced positive roll yield. Studies have indicated that the increase in 

speculation versus hedging may have some influence on the increased incidence of contango in 

commodity futures markets. 

Participants’ general knowledge of the intricacies of the working of commodity futures is likely to be 

minimal, which could result in inappropriate allocations to such an investment fund in the program. 

We also note that it is not a commonly offered investment option in defined contribution programs. 

Conclusion 

Commodity futures offer a diversification benefit, as well as the potential to hedge against inflation. 

However, commodity prices are influenced by demand/supply considerations rather than the intrinsic 

value of a security, and future return expectations are uncertain. Most individual investors will have 

difficulty in determining an appropriate allocation to commodities. Commodity funds are also not a 

common investment option in defined contribution plans. We recommend that the FRTIB not offer 

commodities as an investment option in the TSP. 
 84

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 85

EMERGING MARKET DEBT
 86

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EMERGING MARKET DEBT 

 87

We review the merits of offering an emerging market debt fund as an investment alternative for the 

following reasons: 

 Large and rapidly growing market with current market capitalization of $1.7 trillion 

 Emerging markets have seen improvements relative developed markets in recent years 

– Higher GDP growth relative to developed markets 

– More stable financial condition from large currency reserves and lower public debt than 

developed countries 

– Improved credit ratings relative to developed market bonds 

– Higher yields relative to developed markets 

 Diversification benefits with low correlation to traditional bond and equity markets 

 Daily valued, index funds are available from major index providers, however the maximum 

tradeable dollar amount per day is only $50 million with transaction costs of 25 to 50 basis points. 

Emerging market debt are bonds issued by emerging market countries’ governments and 

corporations. These may be denominated in U.S. dollars (hard currency) or local currencies. 

Emerging market debt indexes come in many flavors -- hard versus local currencies and government 

versus corporate bonds. Emerging market debt, with a market cap of approximately $9 trillion now 

accounts for around 20% of the total global bond market capitalization. We focus our analysis on the 

U.S. dollar (hard currency) part of the market which amounts to approximately $1.7 trillion. Hard 

currency emerging market debt tends to be less volatile because there is no currency risk associated 

with these bonds, while most of the risk associated with local currency denominated bonds is as a 

result of the currency fluctuations. The most commonly used benchmark for the hard currency part of 

the market is the J.P. Morgan EMBI Global Diversified Index. This index consists of sovereign and 

quasi-sovereign bonds. There are no corporate bonds in this index. 

There has been growing interest in emerging market debt for several reasons. First, emerging 

market bonds still command higher yields than comparable U.S. bonds, though low by historical 

standards. Second, emerging market countries have experienced improving fundamentals such as 

rapid GDP growth rates with emerging markets share of global GDP around 40%, lower government 

debt, more investor protections and higher credit quality. Third, emerging market debt has low 

correlations to stocks and traditional fixed income which will provide diversification benefits. 

There are still many risks associated with emerging market debt. The chief concern is always the 

possibility of political instability. Emerging market countries are still very dependent on the export of 

commodities and any slowdown in demand can hurt economic prospects. 
EMERGING MARKET DEBT 

 88

Historical Performance of Emerging Market Debt 

In the table below, we show the historical returns of emerging market debt. We show the returns of 

the J.P. Morgan EMBI Global Index as this is the most widely used emerging market debt index for 

hard currency emerging debt. We also show the returns of the Barclays Aggregate Bond Index 

(benchmark for the F Fund) for comparative purposes. 

Annualized Returns (As of September 30, 2012) 

Trailing Years

J.P. Morgan 

EMBI Global 

Index

Barclays 

Aggregate Bond 

Index

1 20.6% 5.2% 

3 12.3 6.2 

5 10.3 6.5 

10 12.5 5.3 

15 9.6 6.2 

18 Years and 9 Months 10.5 6.2 

The performance of the J.P. Morgan EMBI Global Index has been very strong relative traditional 

bonds over both short and longer time periods. 

The table below shows the volatility (annualized standard deviation) of the indexes over several 

trailing periods. 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years

J.P. Morgan 

EMBI Global 

Index

Barclays 

Aggregate Bond 

Index

5 10.7 3.6 

10 9.0 3.6 

15 12.7 3.5 

18 Years and 9 Months 13.5 3.7 

J.P. Morgan EMBI Global Index has had significantly more volatility than traditional bonds, but it has 

come with significantly higher returns. 
EMERGING MARKET DEBT 

 89

We show the correlations of J.P. Morgan EMBI Global Index relative to the returns of TSP’s current 

investment funds in the table below. 

Correlations (18 years and 9 months ending September 30, 2012) 

 G Fund F Fund C Fund S Fund I Fund 

JPMEMBI 

G Fund 1.00 

F Fund 0.10 1.00 

C Fund 0.02 0.05 1.00 

S Fund -0.03 -0.02 0.85 1.00 

I Fund -0.02 0.01 0.83 0.78 1.00 

JPMEMBI -0.02 0.33 0.54 0.52 0.50 1.00 

Emerging market debt is modestly correlated to the C, S, & I Funds and has low correlations to the G 

and F Funds. 

Index Investment Options 

The table below shows the amount of assets indexed to emerging market debt indexes by the major 

institutional index fund managers. 

Emerging Market Debt Index Fund Products (assets in millions) – All assets 

Blackrock Northern Trust SSgA 

Emerging Market Debt $7,641 - $168 

Emerging Market Debt Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock Northern Trust SSgA 

Emerging Market Debt - - - 

Approximately, $8 billion in assets are managed to various emerging market indexes, by the leading 

institutional index providers. Most of the assets are managed within exchange traded funds (ETFs). 

Vanguard is also set to launch a fund in the near future. The providers could not tell us what portion 

of the assets were in daily-valued DC plans. 
EMERGING MARKET DEBT 

 90

Below we show the efficient frontiers, based on historical data, using the TSP funds with and without 

emerging market debt as an investment fund alternative. 

As shown, the efficient frontier with emerging market debt as an investment fund alternative 

significantly improves the risk/return trade-off. We must use caution from drawing too many 

conclusions from historical data as the strong returns of the past may not be indicative of future 

returns. Given the tremendous flows into this rapidly growing asset class in recent years, we will 

want to examine the effects on adding emerging markets debt, using our forward-looking estimates of 

risk and return. 

Efficient Frontier -- Based on 18 Years and 9 months of Historical Data Ending 9/30/12

S Fund

I Fund

C Fund

G Fund

F Fund

T-Bills

EM Debt

0%

2%

4%

6%

8%

10%

0% 5% 10% 15% 20% 25%

Annualized Risk

Current Line-Up Adding Emerging Market Debt
EMERGING MARKET DEBT 

 91

Below we show the efficient frontiers, based on Hewitt Ennisknupp’s most recent capital market 

assumptions. Our forward-looking assumptions for emerging market debt are significantly more 

modest than historical returns at 3.4% versus 10.5% historically. The risk estimates are comparable 

to historical at 12.0% versus 13.5% actual. 

In contrast to using historical data, using Hewitt EnnisKnupp’s forward-looking assumptions, there is 

no material benefit from adding emerging market debt to the current investment options. Recent 

strong performance has pushed emerging market yields and expected returns to historically low 

levels. Low expected returns, coupled with fairly high correlations to equities (C, S & I Funds) negate 

any positives such as higher expected returns and low correlations relative bonds and cash (G & F 

Funds). 

Considerations 

Emerging market debt has seen an explosion of interest in recent years from investors looking for 

higher yields from an asset class that has low correlation to traditional bonds. Investors have also 

taken comfort in improving fundamentals with regard to government debts, credit ratings and robust 

growth rates relative their developed counterparts. Larger and more liquid markets have enabled 

large institutional index providers to create index products that track various emerging market 

indexes. 

However, we have to be cautious when evaluating the merits of this asset class based on only 

historical information. While recent performance has been strong, we believe future returns will not 

likely be as strong. There are still significant risks associated with this asset class with regard to 

political risk and the reliance on commodity driven economies. 

Liquidity and cost are also of concern as it is estimated that only a maximum of $50 million of daily 

transaction can be executed at costs of 25 to 50 basis points. 

 Efficient Frontier -- Based Forward-Looking Assumptions*

US Small Cap

International Equity

US Large Cap

Cash

Core Bonds

EM Debt

0%

2%

4%

6%

8%

0% 5% 10% 15% 20% 25% 30%

Annualized Risk

Current Line-Up Adding EM Debt
EMERGING MARKET DEBT 

 92

Conclusions 

While correlations to traditional bonds are low, correlations to equities are fairly high coupled with 

lower expected returns and high risk making this asset class less appealing as a stand-alone option. 

Offering emerging market debt, as a stand-alone option, is not common practice (none of the top ten 

largest public plans offer this option). For these reasons we would not recommend emerging market 

debt be added as an investment fund alternative. 
 93

NON-U.S. SMALL CAP STOCK
 94

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NON-U.S. SMALL CAP STOCK 

 95

We reviewed the merits of offering a non-U.S. small cap fund as an investment alternative for the 

following reasons: 

 Market capitalization of nearly $2.0 trillion 

 Daily valued non-U.S. small-cap stock index funds are offered by major index providers 

 Modest diversification benefits 

 Not part of current investment options 

 Consistent with the approach with respect to U.S. equities to broadly diversify stock exposure 

across the entire market capitalization spectrum, it is becoming a common institutional trend to 

diversify non-U.S. stock exposure into mid and small cap stocks. 

Non-U.S. small cap stocks represent approximately 10% of the overall non-U.S. stock market. These 

companies tend to have market capitalization of $2 billion or less and may be located in both 

developed and emerging markets. However, our focus will be on developed markets as measured by 

the MSCI EAFE Small Cap Index. Non-U.S. small cap stocks are believed to have diversification 

benefits because smaller companies provide more pure exposure to foreign economies. Unlike large 

caps, small cap companies tend to draw most of their sales from their local countries and rely less on 

global trade. As a result, their success is less dependent on the global economy and more on local 

factors. Smaller companies also tend to have higher growth rates. 

The I Fund is benchmarked to the MSCI EAFE Index which does not contain non-U.S. small cap 

stocks. The MSCI EAFE Small Cap Index is well diversified by country and sector with over 2,000+ 

stocks. 

MSCI EAFE Small Cap Index Characteristics (As of December 31, 2012) 

Market Capitalization ($ in 

millions) $1.4 trillion 

Number of Securities 2,177 

Average market capitalization $664 million 
NON-U.S. SMALL CAP STOCK 

 96

The chart below shows the sector composition of the MSCI EAFE Small Cap Index. 

The chart below shows the country exposure of the MSCI EAFE Small Cap Index. 

 

MSCI EAFE Small Cap -- Country Breakdown

Japan, 26.20%

United Kingdom, 22.40%

Australia, 8.90%

Germany, 6.10%

France, 4.00%

Other, 32.40%

MSCI EAFE Small Cap -- Sector Breakdown

Health Care, 5.49%

Financials, 20.40%

Telecommunication 

Services, 1.26%

Utilities, 1.70%

Information Technology, 

8.76%

Materials, 11.08%

Energy, 4.93%

Consumer Staples, 

6.04%

Consumer

Discretionary, 18.75%

Industrials, 21.59%
NON-U.S. SMALL CAP STOCK 

 97

We show the annualized returns, volatility and Sharpe Ratios for the MSCI EAFE Small Cap Index in 

the following tables. The MSCI EAFE Index was shown for comparative purposes. 

Annualized Returns (As of September 30, 2012) 

Trailing Years

MSCI EAFE 

Small Cap Index MSCI EAFE Index

1 12.6% 13.8% 

3 4.7 2.4 

5 -3.0 -4.9 

10 11.2 8.5 

15 5.5 3.5 

19 Years and 9 Months 5.6 6.0 

Annualized Standard Deviation (As of September 30, 2012) 

Trailing Years

MSCI EAFE 

Small Cap Index MSCI EAFE Index

5 25.5% 23.5% 

10 20.3 18.6 

15 19.6 18.1 

19 Years and 9 Months 18.7 17.1 

Sharpe Ratio (As of September 30, 2012) 

Trailing Years

MSCI EAFE 

Small Cap Index MSCI EAFE Index

5 -0.14 -0.24 

10 0.46 0.36 

15 0.14 0.04 

19 Years and 9 Months 0.13 0.16 

As shown in the tables above, non-U.S. small cap stocks have outperformed their larger cap brethren 

over the 3, 5, 10 and 15 year time periods. Non-U.S. small cap stock volatility has been higher, as 

expected, over all time periods. 
NON-U.S. SMALL CAP STOCK 

 98

The table below shows the historical correlations of the MSCI EAFE Small Cap Index relative to the 

current TSP funds. 

Correlations (19 years & 9 months ending September 30, 2012) 

 G Fund F Fund C Fund S Fund I Fund 

MSCI EAFE 

Small Cap 

G Fund 1.00 

F Fund 0.12 1.00 

C Fund 0.02 0.05 1.00 

S Fund -0.03 -0.01 0.85 1.00 

I Fund 0.00 0.03 0.81 0.76 1.00 

MSCI 

EAFE 

Small Cap -0.07 0.02 0.66 0.69 0.89 1.00 

Non-U.S. small cap stocks have modest correlations U.S. equities (C & S Funds), high correlations to 

large cap international stocks (I Fund), but none to bonds & cash (G & F Funds). 

Index Investment Options 

The tables below show the amount of assets indexed to non-U.S. small cap stocks by the major 

institutional index fund managers. 

Non-U.S. Small Cap Stock Index Fund Products (assets in millions) – All assets 

Blackrock Vanguard 

Northern 

Trust SSgA 

Non-U.S. Small 

Cap Index $676 $1,371 $925 $1,093 

Non-U.S. Stock Index Fund Products (assets in millions) – Daily-valued DC assets 

Blackrock Vanguard Northern Trust SSgA 

Non-U.S. Small 

Cap Index $151 $7 -- $664 

Total assets indexed to non-U.S. small cap stocks amongst the leading index fund providers is 

approximately $4 billion. 

Based on the last 19 years and 9 months of historical data, for the MSCI EAFE Small Cap Index, our 

optimization programs do not recommend adding non-U.S. small cap stock to existing TSP 

investment funds. The benefits of modest correlations to other TSP funds have been offset by low 

returns and high volatility. We must caution against using historical performance as the only 

consideration. 
NON-U.S. SMALL CAP STOCK 

 99

Recent poor performance of the index has significantly lowered the 19 year and 9 month return which 

is an input into the optimization. Had this optimization been run five years ago, non-U.S. small cap 

stock would have been shown to improve the risk/return trade-off of the TSP investment program. 

The chart below shows the five year rolling annualized returns of the MSCI EAFE Small Cap Index. 

Recent returns are near historical lows, in contrast to five years ago when they were near historical 

highs. 

Hewitt Ennisknupp’s does not produce capital market assumptions (forward-looking) for this asset 

class. However, we believe a small cap premium (MSCI EAFE Small Cap outperforming MSCI 

EAFE), over the long-term, will most likely exist. In other words, the long-term underperformance of 

non-U.S. small cap relative to non-U.S. large cap as measured by the MSCI EAFE, in the tables 

above, will most likely reverse over the long-run. 

Considerations 

Now that non-U.S. small cap stocks market size has grown to over $2 trillion and several index 

products are now being offered, the same argument could be made for a stand-alone non-U.S. small 

cap as with U.S. small cap. Even though the longest historical period examined underperformed nonU.S. large caps, we believe the small cap premium will be restored over time. 

Non-U.S. small cap stocks have benefits of modest correlations to other equities, due to less 

dependence on global market forces and higher growth rates. However, these benefits also come 

with higher volatility. Very few plans offer non-U.S. small cap and none of the top ten largest public 

sector plans do. 

Only a total of $4 billion of non-U.S. small cap index assets are managed by four major index 

providers. If TSP were to offer a non-U.S. small cap option, it is conceivable that the TSP’s assets to 

this category could easily represent more than half of the AUM of any single provider. 

 MSCI EAFE Small Cap Index -- 5 Year Rolling Returns

-10

0

10

20

30

Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11
NON-U.S. SMALL CAP STOCK 

 100

We would prefer to view the international stock asset class from the broadest level, that is consider 

large and small cap along with emerging market stock, as part of a single asset class or fund 

alternative. Our guiding principals recommend the more broadly diversified an asset class, the better 

it will serve participants. Too many fund alternatives will make education more difficult and 

participation less likely. 

Conclusion 

While non-U.S. small cap markets have grown to an adequate size and index products are now 

offered by major index providers, the level of assets passively managed are still low at only $4 billion. 

We would prefer to take a more broadly diversified view of international stocks. More broadly defined 

investment options will make education easier and participation more likely. Non-U.S. small cap may 

rank second, next to emerging market equity, as one of the higher risk offerings and are not 

commonly offered, as a stand-alone investment option. The high risk associated with non-U.S. small 

cap stocks may result in material losses. 

We would prefer to see non-U.S. small cap included, as part of a broader, international stock 

investment fund alternative invested in their respective market capitalization proportions. For these 

reasons, we would not recommend non-U.S. small cap stock be included as a stand-alone 

investment fund alternative.
 101

APPENDIX
 102

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APPENDIX 

 103

Annual Returns (1992 – 2011) 

Year C Fund S Fund I Fund F Fund G Fund 

MSCI 

ACWI 

Ex-US 

Index 

MSCI 

EAFE 

Small Cap 

Index 

1992 7.6% 11.9% -12.2% 7.4% 7.2% -- -- 

1993 10.1 14.6 32.7 9.7 6.1 -- 37.2 

1994 1.3 -2.7 7.8 -2.9 7.2 -- 8.3 

1995 37.6 33.5 11.3 18.5 7.0 7.5 -2.0 

1996 23.0 17.2 6.1 3.6 6.8 5.1 -0.1 

1997 33.4 25.7 1.6 9.7 6.8 -3.3 -24.6 

1998 28.6 8.6 20.1 8.7 5.8 12.0 5.4 

1999 21.0 35.5 26.7 -0.8 6.0 37.7 17.7 

2000 -9.1 -15.8 -14.2 11.6 6.4 -19.4 -7.6 

2001 -11.9 -9.3 -21.4 8.4 5.4 -19.8 -12.5 

2002 -22.1 -17.8 -15.9 10.3 5.0 -12.9 -7.8 

2003 28.7 43.8 38.6 4.1 4.1 42.3 61.3 

2004 10.9 18.1 20.2 4.3 4.3 21.9 30.8 

2005 4.9 10.0 13.5 2.4 4.5 17.7 26.2 

2006 15.8 15.3 26.3 4.4 4.9 26.5 19.3 

2007 5.5 5.5 11.4 7.1 4.9 16.1 1.4 

2008 -37.0 -38.3 -42.4 5.5 3.7 -46.0 -47.0 

2009 26.7 34.8 30.0 6.0 3.0 43.6 46.8 

2010 15.1 29.1 7.9 6.7 2.8 12.7 22.0 

2011 2.1 -3.4 -11.8 7.9 2.5 -14.3 -15.9 
APPENDIX 

 104

Annual Returns (1992 – 2011) 

Year 

ML High 

Yield 

Index 

Citigroup 

WGBI ExUS 

Hedged 

Citigroup 

WGBI ExUS 

Unhedged 

Russell 

1000 

Growth 

Index 

Russell 

1000 Value 

Index 

MSCI 

Emerging 

Markets 

Index 

1992 17.4 8.0 4.8 5.0 13.8 11.0 

1993 16.7 13.4 15.1 2.9 18.1 74.3 

1994 -1.0 -4.0 6.0 2.7 -2.0 -7.6 

1995 20.5 17.9 19.6 37.2 38.3 -5.5 

1996 11.3 11.8 4.1 23.1 21.6 5.7 

1997 13.3 11.1 -4.3 30.5 35.2 -11.8 

1998 3.0 11.5 17.8 38.7 15.6 -25.6 

1999 2.5 2.9 -5.1 33.1 7.3 66.0 

2000 -5.1 9.6 -2.6 -22.4 7.0 -30.8 

2001 4.5 6.1 -3.5 -20.4 -5.6 -2.6 

2002 -1.9 6.9 22.0 -27.9 -15.5 -6.2 

2003 28.1 1.9 18.5 29.8 30.0 55.8 

2004 10.9 5.2 12.1 6.3 16.5 25.6 

2005 2.7 5.7 -9.2 5.3 7.1 34.0 

2006 11.8 3.1 6.9 9.1 22.2 32.2 

2007 2.2 4.9 11.5 11.8 -0.2 39.4 

2008 -26.4 8.0 10.1 -38.4 -36.8 -53.3 

2009 57.5 2.4 4.4 37.2 19.7 78.5 

2010 15.2 2.5 5.2 16.7 15.5 18.9 

2011 4.4 4.1 5.2 2.6 0.4 -18.4 
APPENDIX 

 105

Annual Returns (1992 – 2011) 

Year 

FTSE 

EPRA 

Global 

REIT 

Barclays 

Inflation 

Linked 

Index 

DJ UBS 

Commodity 

Index 

JPM EMBI 

Global 

S&P Global 

Infrastructure 

Index 

1992 -15.2 -- 3.7 -- -- 

1993 71.6 -- -1.1 -- -- 

1994 -13.6 -- 16.6 -18.3 -- 

1995 19.6 -- 15.2 26.4 -- 

1996 30.9 -- 23.2 35.2 -- 

1997 -7.4 -- -3.4 11.9 -- 

1998 -8.2 3.9 -27.0 -11.5 -- 

1999 8.9 2.4 24.3 24.2 -- 

2000 13.8 13.2 31.8 14.4 -- 

2001 -3.8 7.9 -19.5 1.4 -- 

2002 2.8 16.6 25.9 13.1 -2.8 

2003 40.7 8.4 23.9 25.7 39.0 

2004 38.0 8.5 9.1 11.7 29.6 

2005 15.4 2.8 21.4 10.7 14.2 

2006 42.4 0.4 2.1 9.9 38.6 

2007 -7.0 11.6 16.2 6.3 22.4 

2008 -47.7 -2.4 -35.6 -10.9 -39.5 

2009 38.3 11.4 18.9 28.2 24.0 

2010 20.4 6.3 16.8 12.0 4.8 

2011 -5.8 13.6 -13.3 8.5 -1.3 
APPENDIX 

 106

Correlations (Based on 20-years of data ending September 30, 2012)*

G Fund F Fund C Fund S Fund I Fund 

G Fund 1.00 -- -- -- -- 

F Fund 0.11 1.00 -- -- -- 

C Fund 0.03 0.05 1.00 -- -- 

S Fund -0.02 -0.02 0.85 1.00 

I Fund -0.01 0.03 0.81 0.76 1.00 

MSCI EAFE Small 

Cap Index1 -0.07 0.02 0.66 0.69 0.89 

MSCI ACWI Ex-US 

IMI2 -0.05 -0.02 0.82 0.81 0.98 

ML High Yield Index -0.10 0.23 0.62 0.64 0.62 

Citigroup WGBI ExUS Hedged 

0.24 0.67 -0.08 -0.16 -0.16 

Citigroup WGBI ExUS Unhedged 

0.03 0.44 0.10 0.08 0.34 

Russell 1000 

Growth Index 

0.01 0.01 0.95 0.88 0.75 

Russell 1000 Value 

Index 

0.04 0.07 0.94 0.76 0.78 

MSCI Emerging 

Markets Index 

-0.08 -0.02 0.73 0.75 0.77 

FTSE EPRA Global 

REIT 

-0.04 0.16 0.70 0.69 0.78 

JPM EMBI Global3 -0.02 0.33 0.54 0.52 0.50 

S&P Global 

Infrastructure4 0.06 0.17 0.82 0.79 0.93 

Barclays TIPS 

Index5 0.02 0.72 0.03 0.02 0.08 

DJ UBS Commodity 0.05 0.04 0.33 0.35 0.45 

*For indexes with less than 20 years history, we used the longest common period (see below). 

1) MSCI EAFE Small Cap Index 1/93 

2) MSCI ACWI Ex-US IMI 6/94 

3) JPM EMBI Global 1/94 

4) S&P Global Infrastructure 12/01 

5) Barclays TIPS Index 3/97 
APPENDIX 

 107

Hewitt Ennisknupp Capital Market Assumptions as of 4Q 2012 – 10 Years 

Asset Class Proxies Expected Return Expected Risk 

US Large Cap Equity C Fund 7.5% 21.0% 

US Small Cap Equity S Fund 7.7 27.0 

International Equity (Developed) I Fund 8.4 22.5 

Emerging Market Equity 9.4 31.5 

Cash G Fund 1.3 1.0 

Core Fixed Income F Fund 1.9 3.0 

High Yield Bonds 3.9 14.0 

Emerging Market Debt 3.4 12.0 

Non-US Developed Bonds 

(Unhedged) 

 2.6 10.0 

Commodities 3.8 21.5 

TIPS 1.7 4.5 
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