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529 E-ditorials

02-8: Whither individual funds?
Joe Hurley
Wednesday, October 16th 2002

As some of you know, my wife and I own 529 accounts in quite a few different states (31 to be precise). We have opened these accounts over the past four years, with the majority of our college savings money invested in the "age-based" options that shift over time from stock-weighted to fixed income-weighted portfolios (our children are now 16 and 12). We also have accounts invested in portfolios that are "static," that is, they stick to their original allocation between equity and fixed income mutual funds, ranging from very aggressive to very conservative.

I own one account–Option 4 in the Utah Educational Savings Plan–that is invested 100% in a single equity mutual fund. That fund is the Vanguard Institutional Index Fund. At the time I made this investment in 1999, the Utah 529 plan was receiving accolades for making this low-cost and well-respected fund available on a standalone basis.

Recently, I performed a very simple test to compare the performance of my family's 529 accounts over time. I calculated the cumulative gain or loss through June 30, 2002 for each of our 529 accounts without regard for the period of investment (most have been in place for at least two years). Guess which account showed the biggest loss. It was my single-fund account in Utah, down 30.5%.

I realize the investment analysts will argue that my test was simplistic (not merely simple), and that it provides no meaningful comparative data. And they will be entirely correct. So why am I writing about it? Only because it helps highlight a nagging concern I have about the direction the 529 industry is taking. When I invested in Utah's Option 4, very few 529 plans offered individual mutual funds as options. That situation is changing. An increasing number of states, Nebraska and Texas being the most recent, now allow their residents, and nonresidents in some cases, to choose from an extensive menu of individual mutual funds without going through a broker. This means investors can very easily and inexpensively put all their college savings eggs into one basket.

Don't get me wrong. I'm all for greater investment choice. And it makes sense to me that an investor working with a professional adviser is given access to a menu of individual fund options in a 529 plan. (A large number of the broker-sold 529 plans offer individual fund options.) If the adviser is doing his or her job, individual funds will be appropriately mixed and matched to suit the investor's financial situation and investment time horizon.

I also know that many individuals are knowledgeable enough to select the right individual funds on their own without a financial adviser. Others are not as capable, however, and the risk of making bad decisions is amplified when there is a specific need for the money, i.e., to pay college bills, within a few years. I have to admit to being a little surprised by the states that are offering individual mutual funds in their direct-sold 529 plans. If families later decide they have lost part of their college savings because they were permitted to make bad investment decisions, the states will have to shoulder at least part of the blame. We may even see some type of regulatory backlash coming out of Washington, with the section 529 rules tightened up as a result.

Will I be using some of the new individual fund options? Sure I will. But I still happen to like my age-based accounts and the fact that faceless teams of investment technicians are sitting in the back rooms of office buildings designing MY college savings portfolios. These MBAs, CFAs, and Other-As are applying fancy computer-driven algorithms based on modern portfolio theory to make sure that my account with their 529 plan is properly balanced and diversified. Although they don't know me personally, they do know the ages of my children and the fact that I am terrified that college costs will impoverish me within a few short years.

With the individual fund movement pretty well established, it now becomes incumbent upon the states to do whatever they can to make educational materials and investment planning resources available so that families coming directly into their programs (i.e. not through a financial adviser) have the best chance to make sound investment allocation decisions. If this is done effectively, the risk of bad decisions and government backlash can be minimized, and we all stand to benefit.

Two final caveats:

First, I do not mean to pick on Utah's 529 program. Option 4 continues to offer a low-cost and well-respected mutual fund in Vanguard's premier equity index fund, and as the market recovers over time, it may become a stellar performer. As everyone knows, past results are not necessarily an indicator of future performance. Interestingly, the account that turned in the best returns in my simple test was also from the Utah 529 plan. Its Option 1 has not only provided me with a nice rate of interest, but has been gracious enough to credit my account with earnings from a separate endowment fund. My Option 1 account has generated a cumulative 21.5% return from its early-1999 inception date to June 30, 2002.

Second, I do not recommend that you open 529 accounts in 31 different states. I do it, and suffer under a continual avalanche of paper, because it helps me provide you with objective information about the programs. Nice guy, huh?

You can find historical performance for just about all of the 529 savings programs on our web site.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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