Federal Thrift integrates new ex-China index; inspires others

The $946.9 billion Federal Retirement Thrift Investment Board (FRTIB) the Washington-based defined contribution plan for US federal civilian employees has finally integrated a new index that excludes China and Hong Kong for its $86.2 billion I Fund after a year-long implementation process.

Speaking during FRTIB’s November 2024 investment committee meeting, Sean McCaffrey, CIO of the retirement fund for 7.2 million federal employees said the fund’s investment managers had completed integrating the new index MSCI ACWI IMI ex USA ex China ex Hong Kong, replacing MSCI Europe, Australasia and Far East (EAFE).

FRTIB’s strategy has inspired action from US state treasurers helping oversee other public pension funds in the country. At the end of last year, a coalition of 15 state treasurers issued a joint statement urging state governments to follow FRTIB’s lead and divest their pension funds from the People’s Republic of China (PRC). The letter warns pension fund fiduciaries that “investments in China are no longer prudent investments” continuing, “the time has come to divest from China: investments in China increasingly present red flags.”

FRTIB’s decision to change the index followed a routine view of the four benchmark indexes used across the whole portfolio. Aon, the fund’s investment consultant, wrote at the time that tensions between the US and China, restrictions in tech investment and the export ban of US technology to China, outweighed the benefits of expanding the I Fund to include China or retaining exposure to Hong Kong.

Aon also flagged the risk of unforeseen events incurring transaction costs and causing performance and volatility swings. The announcement of investment restrictions can cause the value of a stock to decline at a time where the investor is forced to sell. Given the asset size of the I Fund, forced selling or restricted investments could incur higher than average market impact costs due to liquidity challenges, wrote Aon.

Tapping additional returns

The decision isn’t only rooted in eliminating China risk. By broadening the index, FRTIB aims to expand investment opportunities and improve the I Fund’s risk-return profile. The new index provides exposure to 5,621 large-, mid-, and small-cap stocks in 21 developed markets and 23 emerging markets, representing 90 per cent of non-US market capitalisation. The adjustment to the I Fund will more than double the number of countries included in the fund, and will change the number of equities by 700 per cent.

In contrast, the old index provided the fund with exposure to 798 large- and mid-cap stocks in 21 developed markets, representing 55 per cent of non-US market capitalisation.

The new index is also expected to outperform on a risk-adjusted basis over the long term: historical analysis shows the risk-adjusted returns for the new index have exceeded those of the MSCI EAFE Index over the past 20 years.

During the transition period, the managers followed unique transition benchmarks they developed with MSCI. However from now each manager’s performance will only reflect the new index. To implement this change, the fund’s managers BlackRock and State Street independently coordinated with MSCI to develop transitional benchmarks.

The bulk of FRTIB’s assets (43 per cent) are invested in the $415 billion Common Stock Index Investment Fund (C Fund). Other funds comprise the $110.6 billion Small Capitalisation Stock Index Investment Fund (S Fund) and the $34.8 billion Fixed Income Index Investment Fund (F Fund) Around $299.8 billion is invested in a G fund, an internally managed passive Treasuries allocation.

Until 2021, BlackRock ran four key funds. However, following a consultation in 2015 that flagged concentration risk FRTIB hired State Street Global Advisors to reduce its vulnerability to BlackRock suffering a black swan event following a series of RFP’s.