From the November 2010 issue of Investment Advisor • Subscribe!

How ETFs Benefit 529 Plan Investors

529 plans that invest in ETFs can provide peace of mind that comes from knowing what you own

Every investment vehicle is under scrutiny these days, and 529 plans are not immune. These plans are still in their infancy, and were just gaining traction when the downturn in 2008 brought about an unfortunate convergence of investor uncertainty and opacity of holdings. At a time when full transparency was perhaps most important, many investors were left in the dark.

Why the Transparency Offered by ETFs is Important
The use of ETFs in 529 plans can answer a host of needs that existed even before the economic climate turned harsh, but one such need was brought front and center by a rash of surprising losses in some states’ traditional 529 plans during the 2008 market downturn. These plans’ so-called “conservative” bond portfolios held underlying funds that invested in illiquid, leveraged derivatives. At the time, investors in these plans did not have the transparency of holdings offered by underlying investments in ETFs. So, as the markets worsened, many investors rushed for the exits, locked in their losses, and, in some cases paid needless taxes and penalties—adding insult to injury. The travesty is that many of those hardest hit were investors whose children and grandchildren were closest to needing the money to pay for college tuition.

Alternatively, 529 plans with portfolios that invest in index ETFs can provide clients and their advisors with the peace of mind that comes from knowing what you own and that underlying investments are consistent with a portfolio’s objective.

But, many plans today still pose the same concerns to investors and their advisors, because in most cases, it’s virtually impossible to know what the plan’s portfolios’ underlying investments are currently holding—and in the case mentioned above, investors didn’t know until it was too late. Compounding this problem is the fact that the regulators still only allow investors one investment allocation adjustment per year. (Temporary guidance allowed adjustments twice a year for 2009 only.)

This need for transparency is one of the major reasons behind the rise in interest of 529 plans with portfolios that invest in ETFs. ETF-based plans enable investors and their advisors to have visibility into what their portfolios own—one such plan even updates all the holdings of each underlying ETF on its website daily.

The Benefit of Lower-Cost ETFs in 529 Plans
Before the market meltdown of 2008, much was written of the significance of fees in 529 plans, and in these times of relatively modest returns, who can argue? When investors were getting more than 20% annual returns from their 529 plan investments, even an annual expense ratio north of 200 basis points didn’t seem to bother many advisors or their clients. Thankfully, there are now advisor-sold plans with reasonable asset-based fees—between 60 and 110 basis points, including underlying fund expenses, program management fees and state fees—in particular those plans which are ETF-based.

A Marriage Whose Time Has Come
In this period of extraordinary volatility, these benefits provide greater comfort to investors. It should be no surprise that ETFs continue to climb in popularity—as evidence, there are more than 800 new ETFs in the registration process. And, as investors continue to seek these same benefits when investing for higher education, the combination of ETFs and 529 plans will undoubtedly continue to grow as well.

Stephen Jobe
Director, 529 Programs
BlackRock

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