College Savings Plans Start To Welcome Low-Cost ETFs & the Tax Benefits

PAUL KATZEFF, INVESTOR'S BUSINESS DAILY writes: Mutual funds still hold bragging rights when it comes to favorite investment vehicle in 529 savings plans.

But ETFs are giving it the ol' college try in terms of closing the gap.
There are 92 plans in 50 states and the District of Columbia, according to AKF Consulting, an adviser to state administrators of 529 plans.  Of the 92, 15 offer ETFs. That's up from 10 offering ETFs among the 94 plans that existed in February 2012.

The growth of ETFs in 529s is mainly due to interest from financial advisers, says Andrea Feirstein, managing director of AKF Consulting.
Roughly one-third — 31 plans — of all 529s sell accounts only through advisers. Nine of those 31 offer ETFs.

Among the 61 direct-sold 529s, only six offer ETFs.
"Advisers like them because ETFs give them very specialized investment options," Feirstein said. "And ETFs tend to be lower cost. So an adviser who puts an ETF into a client's account is lowering the investment expense, which should give them better performance (than a mutual fund that invests the same way)."

At least that's the theory. Actual results sometimes deviate from that.
This year through April 30, stock mutual funds have averaged a 10.08% gain vs. 8.60% for stock ETFs, according to Morningstar Inc. Over the past five years mutual funds' average annual gain was 3.63% vs. 3.36% for ETFs.

That outperformance was despite an average annual expense ratio of 1.36%, nearly triple the 0.5% of stock ETFs.

U.S. stock ETFs outperformed U.S. stock mutual funds in both time periods.

Tax Benefits
One of the key attractions of ETFs is dampened by 529-plan rules. Unlike mutual funds, which are priced once daily after the end of trading, ETFs trade and are priced throughout the day. But 529 rules bar account owners from trading an account more than once a year. Underlying investments, whether mutual funds or ETFs, trade whenever they like. Still, index-oriented funds of either stripe tend to rebalance infrequently anyway.

Tax advantages are a large part of the appeal of 529 plans.

Investment earnings grow on a federal tax-deferred basis. Withdrawals used for qualified college costs are tax free. And some states also allow income-tax deductions for contributions.
The rise of ETFs inside 529s reflects the overall growth of ETFs.
ETFs had $1.5 trillion in assets as of April 30. That was up 144% from $610 billion five years earlier.
Mutual fund assets hit $10.1 trillion, up 31% from $7.7 trillion.

Steve Coyle, head of the U.S. subadvisory group at State Street Global Advisors, which runs the SPDR line of ETFs, says that ETFs let 529 investors build a diversified portfolio with low-cost funds.
"It's a marriage between the sophistication of an institutional portfolio and the college savings needs of individual investors," Coyle said.

Investors who don't want to make their own investment decisions as their child approaches college can use ETFs that become increasingly conservative over time, like target-date mutual funds, he says.