Morningstar measures college-savings plans' risk-adjusted performance.
Parents and grandparents socking money away in 529 plans want some assurances that their college savings are performing well in these tax-advantaged investments. In a recent study of the 529 college-savings plan industry, Morningstar stacked up the plans' long-term, risk-adjusted performance. The research uncovered few standouts or complete duds.
The study compared the Morningstar Ratings of the 529 plans' underlying investment options, most of which ultimately are invested in mutual funds. The Morningstar Rating for funds, better known as the star rating, compares risk-adjusted returns of investments in the same category and provides college savers an easy gauge to see whether their 529 investments brought more return with less volatility. Both mutual funds and 529 investments earn 3 stars if their risk-adjusted performance is near the middle of their peer groups, 4- and 5-star investments outperformed their peer groups, and 1- and 2-star investments underperformed their peer groups. The Morningstar Rating uses a bell-curve distribution, so the largest subset of funds receives 3 stars.
The table below aggregates the Morningstar Rating by plan on an asset-weighted basis. This calculation puts more emphasis on options within a given 529 plan that hold more assets, so as to better represent the investor experience.
None of the plans had an asset-weighted Morningstar Rating of 4 stars or greater, but slightly more than one third of the plans with adequate performance histories had asset-weighted Morningstar Ratings of 3 stars or greater. This indicates that these plans' assets posted largely competitive returns. Morningstar could not calculate asset-weighted Morningstar Ratings for 18 plans because none of their investments had at least three years of performance history.
Passively managed plans with low fees are well-represented at the top of the list. New York's 529 Program (Direct), Colorado's CollegeInvest Direct Portfolio, and The Vanguard 529 College Savings Plan in Nevada are all primarily indexed plans and earn high marks for their reasonable expenses. Plans with actively managed options or options with a blend of active and passive management, such as the Maryland College Investment Plan, Alaska's T. Rowe Price College Savings Plan, and Ohio's CollegeAdvantage 529 Savings Plan also had strong risk-adjusted returns. Broadly speaking, the plans with the best asset-weighted Morningstar Ratings (those with averages exceeding 3.5, for example) tended to be competitively priced within their peer groups. Although blended and actively managed plans, such as the T. Rowe Price College Savings Plan, are more expensive than pure index offerings like The Vanguard 529 College Savings Plan, they are still relatively inexpensive compared with similarly run offerings.
While high Morningstar Ratings are a good signal of past performance, college savers should remember that they come with limits. Morningstar Ratings compare investments within their Morningstar category peer groups. Morningstar's 529 categories often include a wider range of investment styles than the comparable open-end mutual fund category. For instance, there is no 529 category for emerging-markets investments as in the open-end mutual fund universe. Such 529 investment options are included in the all-encompassing non-U.S. equity category and contribute a wider range of returns than one would see across the numerous non-U.S. equity categories for open-end mutual funds.
Additionally, almost every equity-heavy 529 peer group has a large allocation to index funds. If the indexed investments all deliver similar returns, active management likely will be heavily penalized or heavily rewarded for deviating from the group average. For instance, among static large-blend 529 investments, the category average return for calendar year 2012 was 15.63%. Options that underperformed by 1 percentage point landed in the 75th percentile of the peer group for the time period, while options that returned 1 percentage point more than the average 15.63% return landed in the 27th percentile of the category for 2012. Large-blend mutual funds had a much wider dispersion of returns. The large-blend category average return for 2012 was 14.96%. A fund that underperformed the category by 100 basis points landed in the group's 68th percentile, while one that outperformed the category average by the same amount landed in the 36th percentile. The smaller dispersion of returns for 529 large-blend options means that deviations in performance have a larger impact on relative rank.
Finally, it is worth noting that plans with poor average asset-weighted Morningstar Ratings may not be at the bottom of the list for long. Several plans have a small percentage of assets in funds that earn a Morningstar Rating; the Michigan Education Savings Program, for example, has only 23% of assets with a Morningstar Rating. These plans' averages may change significantly as more funds earn Morningstar Ratings. Meanwhile, other poorly performing plans where most assets receive a Morningstar Rating, like Texas' Lonestar 529 Plan, are less likely to change simply because their investment options gain a longer history. There are few long-tenured poorly performing plans because plans with poor historical performance usually are either completely rebuilt or heavily reconstructed. In Wisconsin, for example, the Tomorrow's Scholar 529 Plan and EdVest 529 Plan implemented significant changes in 2012 after the plans turned in mediocre performances in years prior.