Exchange traded funds (ETFs) have taken the financial industry by storm over the last few years as investors have flocked to the fund type. Blending the line between traditional indexing and active trading, investors have poured more than $1.1 trillion into roughly 1,251 different funds since their creation in 1993, according to data from State Street. Much of this growth has come at the cost of traditional mutual funds, which continue to see outflows.
Faced with shrinking contributions and meager returns, ETFs are now making inroads into 529 college savings vehicles and 401(k) retirement plans as administrators hope to make up for the market's recent poor performance and volatility.
For the countless parents who have joined such plans in order to help pay for their children's future college expenses, the question remains, are there any real benefits to adding the security type to their plans?
Rising Tuition Amid Poor Performance
With the cost of getting a college education rising all the time, financially savvy parents, and grandparents for that matter, are doing everything they can in order to help turn the tide. For many, that means turning toward state-sponsored 529 plans as a way to save for their children's future room and board, tuition and books, etc. The beauty of a 529 account is that investments in the savings plan are not subject to federal tax as long as the money is used for college expenses. Currently, mutual funds make up the lion's share of most 529 plan assets; however, that is quickly changing.
In an effort to attract more investors by providing increased diversification and extra protection from volatility, several states have now added ETF options to their portfolios. States such as New York and Arkansas now offer the security type as an option in their plans, while Nevada's Upromise 529 recently moved almost exclusively over to ETFs and shifted away from traditional mutual funds.
The hope is that the ETF-based plans will be able stem the losses 529s have recently suffered. After the 2008 downturn, several plans added a wider range of mutual funds and accounts that guaranteed principal. However, plans still on average lost almost 1% last year, according to Morningstar, while the broad S&P 500 returned about 2%.
Let's be clear, this isn't about being able to day trade your kids' tuition money. Most 529 plans are set-up as an asset allocation option such as aggressive, conservative, etc., or as target-date option. The underlying investments are chosen by plan administrators and sub-advisors and most 529 plans only allow investors to change their portfolios once a year.
Still Many Benefits
While the ETF hallmark of inter-day tradability is lost in the plans, there are some major benefits, the biggest of which are lower costs. According to State Street, t he average annual cost for its ETF-based 529 plans is just 0.49%. That compares to an average cost of 0.87% for open-end fund based plans. Likewise, Arkansas' ETF plan, which is sold exclusively by financial advisers, costs only around 0.61%. The average fees in adviser-sold plans are normally a high 1.12%.
Then there is the performance to consider. The Arkansas 529 plan - which uses BlackRock's iShares line of ETFs - returned 3.3% in 2011 and has returned an average of almost 1% since 2007. The average 529 plan lost nearly 3% during that time.
Overall, the flexibility of using ETFs seems to be working, as plan administrators can minimize losses and help boost performance on a daily basis. While adding this active trading into the recipe does introduce the new risk of the manager to make the right call, adding ETFs to the 529 mix seems to be a prudent choice for plan sponsors.
The Bottom Line
With more states adding exchange traded funds to their 529 plans, the real benefactors will be investors and their children's lower student loan bills. The security type will help lower plan costs as well as help to drive performance. Ultimately, the addition of ETFs could be seen as a win-win situation.
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