Expenses and structural differences contribute to a performance gap; tax benefits often close the shortfall.
College savers choosing 529 plans often give up some investment performance in exchange for the plans' tax savings, a new Morningstar study has shown.
As part of its annual study of the 529 college-savings plan industry, Morningstar's team of analysts dissected the performance of the 529 plans. On average, the long-term performance of 529 investment options continues to look unimpressive relative to that of similar peers in the broader mutual fund universe.
Over the five-year period through Dec. 31, 2013, five of the eight most-prominent static Morningstar 529 categories trail their respective open-end fund categories on an annualized basis. For the most part, the gap was relatively narrow. For example, among large-blend investments, the average 529 option trailed the analogous open-end mutual fund by roughly 0.30 percentage points per year. The largest gaps are with the large-value and conservative-allocation categories, in which the average 529 investment trailed its average open-end peer by more than 1 percentage point per year.
In a few cases, however, 529 categories have outperformed their mutual fund categories. For the five-year period ended in 2012, 529 investment options in the short-term bond category again edged past their average open-end rival. For the past five years through Dec. 31, 2013, the 529 investment options in the intermediate-term bond and aggressive-allocation categories also earned a slight performance edge over similar mutual funds.
Headwinds for 529s
Several structural features of 529 investment options can lead to performance differentials relative to their open-end peers. For one, most 529 investment options carry heftier price tags than similar mutual funds, creating a constant headwind for their returns.
In addition, within equity categories, the typical 529 investment option has a larger stake in international stocks than does the typical mutual fund. For example, in Morningstar's 529 static large-blend category, the average 529 invests 16% in international stocks, while the typical traditional large-blend mutual fund has only 5% invested abroad. With U.S. stocks on a tear during 2013, traditional mutual funds received a relative boost.
Also, 529 investments tend to take on more passive exposure than their mutual fund counterparts. In markets where active management shines, investors can reasonably expect index-heavy 529 investments to lag. In markets where active management suffers, 529 investments may do better on average (assuming they can overcome the higher 529 fee hurdle). For example, many active large-blend managers have had trouble beating the S&P 500 Index since 2010, which allowed indexed options' returns to exceed the 529 large-blend category average. The opposite was true in 2009, when active managers outperformed.