Fees continue to fall, but mutual funds and indexes post better returns.
College savers are socking more money into 529 plans, even though the investments' returns have not been as strong as similar mutual funds, according to a Morningstar industry study released today.
Traditional 529 plan industry assets topped $166 billion in 2012, up about 25% over the previous year. To be sure, much of the increase in 529 assets can be attributed to market gains. The S&P 500 Index was up 16%, while the Barclays U.S. Aggregate Bond Index rose more than 4% last year. But organic growth remains significant--likely in the double-digits.
Despite these gains, however, Morningstar's study found that 529 investment options haven't kept pace with similar mutual funds when it comes to performance. For the five-year period through Feb. 28, 2013, eight Morningstar 529 categories of non-age-based options posted returns that were lower than the returns for mutual funds in similar categories. For example, conservative-allocation 529 investment options gained 3.73% per year on average for the period, while similar mutual funds were up 4.34% per year.
Morningstar also analyzed returns for age-based 529 options. Because there are no analogous mutual fund categories, the study compared the age-based options' returns with those posted by a combination of indexes that reflect the typical age-based option's asset allocation in each category. For the five-year period through Feb. 28, 2013, all of the Morningstar age-based 529 categories posted average returns that fell short of the combined benchmarks' returns--some by as much as 2 percentage points per year, on average. To be sure, most 529 age-based options' assets are more diversified than the three benchmarks in this test, but the 529 returns are nonetheless disappointing.
One reason why 529 options have trouble keeping up with mutual fund or index returns may be their higher fees. Investors are paying less in annual fees than in years past, thanks to program managers negotiating for lower fees and substituting cheaper investments for more-expensive ones. The average annual expense ratio for each Morningstar 529 category declined between July 2011 and January 2013. For example, the typical large-blend 529 investment cost 1.05% in January 2013, down from 1.13% in July 2011.
Lower fees certainly are a plus, but most 529 investment options' expense ratios remain higher than similar mutual funds. The typical 529 investment options in the large-value, large-growth, conservative-allocation, moderate-allocation, aggressive-allocation, intermediate-term bond, and short-term bond categories are more expensive, on average, than in similar mutual fund categories. The average price gap ranged from 14-35 basis points. One of the widest average price differentials was among short-term bond investments, with 529 investment options charging 34 basis points more per year than mutual funds and further diminishing returns on investments with small absolute returns.
Another explanation for 529 investment options' poorer returns is their strategies. Indexing is much more common among 529 investments than it is among mutual funds, making it likely that the 529 industry's returns will hew closely to the market's, minus fees. For instance, in Morningstar's 529 large-blend category, 28% of the options are indexed, while 15% of traditional mutual funds in Morningstar's large-blend category are indexed. This makeup means that 529 large-blend investments are more likely to underperform their mutual fund counterparts in periods when actively managed strategies are outperforming indexes.
The non-age-based 529 categories also typically feature higher-quality stocks and bonds, thus limiting equity and credit risk. Fear of losses, particularly in the wake of 2008, has led plan managers to select options with higher credit quality or more cash. To wit, the intermediate-term bond category for 529 investment options has an average credit quality of A and 17% of assets in cash, while the same category for traditional mutual funds has an average credit quality of BBB and just 4% of assets in cash. In markets where active management and lower-quality bonds rally, 529 investments are understandably left behind.
Similarly, notable differences in age-based options' actual asset allocation relative to the index benchmark can help explain their underperformance. 529 age-based options often include exposure to smaller companies' stocks, non-U.S. equities, and a broad array of bonds that are not included in the blended benchmark. Exposure to these asset classes and subasset classes affects performance. Higher allocations to international stock, for instance, would have hurt 529 categories' returns relative to the blended benchmark for the three- and five-year periods.
Returns for 529 investment options may not be keeping pace with mutual funds', but they still hold appeal for college savers. Some states offer tax benefits on contributions to 529 investment options, and all 529 plans' investment gains are not subject to tax, whereas mutual fund investors do pay taxes on their gains. All Morningstar 529 categories have posted gains for the five-year period through Feb. 28, 2013, helping college savers grow their nest eggs in a tax-sheltered investment. Depending on the size of a family's investment, the combination of state tax benefits and tax-sheltered gains can tip the scale in 529 plans' favor.
For more info on 529 plans, visit Morningstar's Save for College Center.