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ETFs in 529 Plans

We've talked before about the possibility that ETFs will replace mutual funds in many 401(k) retirement plans and the implications that might have for retirees. While most 401(k) plans have not yet adopted ETFs in their investment lineups, ETFs are becoming more common in another type of long-term savings plan known as a 529 Plan.

529 Plans are typically run by states and are used to save for future education expenses such as college. There are several ways to take advantage of 529 Plans. One common approach is to use a 529 as a savings plan that credits growth based on the value of one or more investments. Typically, 529 Plan investments have been mutual or money market funds, similar to those conventionally found in 401(k) funds. Recently, however, several states have begun including ETFs in their investment lineups, which could have major effects on retirees. ETF issuers have created branded 529 Plan options, which have recently received favorable ratings by Morningstar.

Including ETFs in 529 or 401(k) plans may have several advantages. ETFs typically have lower fees than comparable mutual funds, and those fees have dropped even lower recently amongst intense competition. There are also now a wide variety of ETFs available which can be used for asset class diversification and other sophisticated strategies.

But ETFs can also be very risky. ETFs can be vastly more complex than mutual funds, and use leverage and derivative products to a much larger extent. Newer ETFs are also more likely to fail than established ETFs, and issuers may push failing funds into 529 plans in an attempt to increase fund flows.

We've pointed out before that active funds rarely beat passive funds on an after fee basis. If passive ETFs are replacing passive mutual funds, there could be a cost savings, but 529 investors will not be able to benefit from the more frequent tradability of ETFs. This is because 529 plans typically only allow an infrequent (annual) allocation change and as a result, there is very little difference between holding an ETF or a mutual fund if their holdings are identical (when it comes to tradability at least). If, on the other hand, active ETFs are used, the cost savings might be small since active ETFs often have higher fees.

Bottom line: ETFs and mutual funds are similar in many ways but are in fact very different types of investments. A shift from mutual funds to ETFs in tax-advantaged savings plans such as 529 or 401(k) plans would be a major development that would require a significant amount of investor education.