College-Savings Plans Get ETF Fever

Exchange-traded funds are gaining wide acceptance with investors, often serving as more tax-efficient and cheaper alternatives to actively managed mutual funds. As such, ETFs are increasingly being included in 529 college-savings plans. Sixteen plans now include at least one ETF option, up from just a handful a few years ago.

The plans are adding ETFs for a variety of reasons, often with a goal of cutting costs, attracting assets, or outperforming actively managed competitors. While the plan sponsors have high hopes these relatively new investments will attract interest from investors, college savers seem less certain. Arkansas, one of the first states to start using ETFs in its plan, has struggled to attract assets to its iShares 529 plan. And while some states are busy launching new ETF-based lineups to market to registered investment advisors, it's unclear whether RIAs will be willing to switch assets from their current plan to an unproven option. Let's take a look at how these investments affect college savers and which plans are getting into the ETF action.

Does Adding an ETF Make Sense for 529s?
When 529 plans replace an actively managed fund with a passively managed ETF, they almost always cut costs. For example, Nebraska sliced expenses for small-cap exposure by 75 basis points when it removed an actively managed fund for a passive ETF in three of its plans, lowering the overall costs of its age-based options by several basis points as well.

Index mutual funds are typically priced just as competitively as their ETF counterparts, but not all indexes are available to all 529 plans. For example, Vanguard offers only no-load open-end funds, thereby limiting which advisor-sold plans can offer their open-end index funds. The fund family’s ETFs, however, can be included in advisor-sold plans. Keep in mind, though, that 529 college savers compensate their advisors through other layers of costs built into the 529 plan's expense structure, so ETFs aren't the same bargain in advisor-sold plans as they are for direct investors.

Aside from a cost advantage, other plans may add ETFs because they can be traded intra-day. ETFs offer faster response times to market news than do open-end mutual funds, which are priced only once a day, after the end of the trading session. Nevada’s Upromise plan switched to ETFs in 2012's first half both to lower plan costs and to allow the plan's asset manager, State Street Global Advisors, to tactically allocate the age-based options' assets. The managers at SSgA are using ETFs to quickly tweak some of the options' asset-class exposures, up to 10% of the options’ assets.

There are risks associated with such on-the-fly trades, however. They’re difficult to get right consistently, and for now, such moves within a 529 plan can be executed only by the pros. Unlike traditional brokerage accounts where investors can make full use of this feature and trade as they please, individual investors in direct-sold 529s are able to rebalance their accounts only once per year.

Who's All-In
The first all-ETF plan was launched by Arkansas in 2007. The iShares 529 Plan's age-based options, constructed using a diverse set of iShares' ETFs, have earned relatively strong risk-adjusted returns and are among the cheapest advisor-sold options on the market.

ETFs from iShares are also used in Indiana's CollegeChoice advisor-sold plan, which includes ETF age-based options as well as a few static ETF options. Unfortunately, Indiana's age-based options have not performed as well as Arkansas' plan. Different teams set the allocation decisions for the two plans, so the variation in results can be partly attributable to their respective asset allocation. Indiana's aggressive equity stake, for example, has produced returns that are similar to Arkansas’, but they’ve been more volatile, leading to a wide gap in risk-adjusted results. In addition, Indiana's total expenses are also higher than Arkansas', which undercuts the cost benefit of using passive strategies.

Maine's NextGen College Investing direct-sold plan also features iShares ETFs in an age-based track. Launched in 2010, its performance history is relatively short. The plan also charges relatively high fees and therefore is unlikely to outperform its passive peers.

As mentioned above, Nevada launched SSgA Upromise 529 Plan, an all-ETF lineup from State Street Global Advisors, available to investors since April 2012. The passive-only plan offers a well-diversified lineup. Total fees for the age-based options, however, range from 45 to 55 basis points; Nevada’s plan featuring Vanguard index funds is roughly half that price but carries a relatively high $3,000 minimum investment.

Just Testing the Waters
A few states, including Missouri and Ohio, offer iShares' ETFs as part, but not all, of their age-based or standalone options. In May, New York's 529 Program's advisor-sold plan began using State Street ETFs along with actively managed funds from JP Morgan. The NEST and TD Ameritrade plans in Nebraska swapped out a pricey small-cap fund for an ETF in June 2012, and the NEST advisor-sold plan also traded a mid-cap index open-end fund for an ETF. Exchanging the actively managed small-cap fund for an ETF cut expenses for the plan's age-based options by up to 5 basis points, although the index open-end fund and ETF that switched places were on par for price.

In October 2012, South Carolina will roll out an updated lineup for its direct- and advisor-sold Future Scholar plans managed by Columbia, trading out some of its index mutual funds as well as actively managed funds for ETFs. The direct-sold plan will cut costs so dramatically that it will become the cheapest age-based option on the market.

After these changes are implemented, the fixed-income sleeve of the direct-sold plan will swap actively managed and index funds from Columbia for an iShares TIPS ETF and combine the ETF in a portfolio with Vanguard bond index funds. While the index funds and ETF combo are a lower-cost alternative to the existing lineup, Vanguard also offers a Treasury Inflation-Protected Securities index mutual fund that, while not selected for the plan, is even cheaper than the iShares ETF.

Overall, while ETFs are gaining popularity, there isn't a clear case to be made for their inclusion in 529 plans. Most index open-end funds can offer the same cost advantages as ETFs can, and plan sponsors rolling over an investment lineup between index funds and ETFs may have a hard time explaining how they'll recoup transaction costs.

What’s more, ETFs’ tax advantages aren’t relevant to the 529 market. ETFs are typically a tax-efficient investment product, as they rarely pay out capital gains, but 529 accounts grow tax deferred regardless, and qualified distributions can be taken tax-free.

Morningstar's 529 Plan Ratings
To find out more about your 529 investments, visit the Real Life Finance tab of Morningstar.com. The Save for College tab features Morningstar’s ratings on more than 50 529 plans. These annual ratings will be updated later this month, so check back for a more in-depth look at each plan mentioned in this article. 

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