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529 College Savings Plans Underperform Similar Mutual Funds -- Morningstar

On Monday, Morningstar Fund Research issued their 2013 529 College-Savings Plans Industry Survey, which reviews the performance of the 529 industry in 2012. Their study finds that "college savers are continuing to invest in 529 college-saving plans at an impressive clip, even though their performance has lagged that of similar funds in recent years."

529 Plans are typically run by states and are used by investors to save for future education expenses such as college tuition on a tax-advantaged basis. Such plans allow for tax-free appreciation of invested principal and is typically allocated between several diversified mutual funds (though many plans are starting to use ETFs for similar purposes). The allocations typically change with the age of the beneficiary, similar to target-date retirement funds, which is known in the industry as a plan's 'glide path.'

Morningstar's report finds that "over the five-year period through Jan. 31, 2013, all but one Morningstar category of 529 investment options underperformed the analogous open-end fund category on an annualized basis." The difference was larger for bond-heavy categories than equity-heavy categories. Morningstar attributes most of this discrepancy to expense ratios, which tend to be higher in 529 plans relative to similar mutual funds:

A figure showing a bar graph demonstrating 529 investment options and mutual fund average total expense ratios by percentage in 2011 and 2013.
SOURCE: Morningstar, Inc. (Exhibit 9, 2011 omitted)

While these higher fees may lead to underperformance of 529 assets relative to those of comparable mutual funds, the Morningstar study did not attempt to quantify the tax benefits of 529 plans, but note that "tax benefits should theoretically make up for much--if not all--of the shortfall." It will also be interesting to see if 529 plans that more fully adopt ETFs, which often have lower expense ratios, make up any of this difference.