Picking the Right ETFs for Your 529 Plan

Exchange-traded funds (ETFs) haven't gained a great deal of traction in the 529 marketplace. The advantages of ETF products don't align well with the structure of a 529 plan. For example, the Internal Revenue Service (IRS) allows for only one change to 529 plan holdings within a calendar year. A primary advantage of ETFs, their intraday tradability, is negated when there is little trading allowed. ETFs do exist as options in 529 plans from states including Missouri, Arkansas and Nevada, so it's still important to know which ETFs are right for saving for college.

Choosing the Right Type of ETF

Considering that tuition rates continue rising far above the rate of inflation and the cost of a typical year of college runs north of $20,000 (and more for private school), it's important to maximize the return on every dollar invested and to build a college savings portfolio wisely.

One of the best ways to maximize the overall return of a portfolio is to limit expenses. An ETF's expense ratio shows how much the fund manager is charging for managing the portfolio. A higher expense ratio means less money ends up in the investor's pocket, making it imperative to choose funds that charge as little as possible. Many passively managed index ETFs would fit well in a college savings portfolio. Index funds from companies such as BlackRock and Vanguard have reputations as low-cost leaders and offer vast arrays of investment options with razor-thin expense ratios.

While low-cost ETFs should be targeted as a general rule of thumb, the composition of a college savings portfolio differs depending on the beneficiary's age. A brand-new 529 plan started for a newborn can take on considerably greater risk because the money will not be needed for almost two decades. Conversely, portfolios for near-graduates should be conservatively invested, since there won't be time to recover from any unexpected market downturns.

Investing for 0-5-Year-Olds

Even if parents start saving for college the minute their child is born, they're still facing an uphill battle. Parents are looking at needing to save several hundred dollars a month right from day one if they plan on funding a full four-year education. That's why it's important to take advantage of the higher returns that equities can offer.

Many parents fear putting their child's college savings into anything but an ultra-safe investment such as certificates of deposit (CDs). After all, parents want to make sure the funds are there when they need them. However, CDs usually offer a return that's not much above the long-term rate of inflation. A college savings portfolio needs to earn a higher rate of return to stay ahead of inflation and keep up with the rising cost of tuition.

With a nearly 20-year time horizon, there is plenty of time to ride out any short-term volatility in the markets to earn these higher returns. At this point in a child's life, investors should be targeting a roughly 75% allocation to stocks with the remaining going towards bonds or money market investments. A portfolio like this has historically returned about 6 to 7% and should primarily include low-cost bond and large-cap stock index ETFs.

Investing for 6-10-Year-Olds

As the child begins getting a little older, the time horizon begins to shorten and the portfolio composition should begin turning more conservative. At this point, the allocation to stocks should be lowered but should still remain the majority of the portfolio. A 60% allocation to stocks with the remainder going towards bond funds and money markets would be more appropriate here.

A small allocation to large-cap international stock ETFs should be considered in these portfolios. While international stocks may seem risky in isolation, they provide important risk-minimizing diversification benefits while offering equity returns. Many index ETFs, whether domestic stock, international stock or bonds, have rock-bottom expense ratios and should continue to be targeted for college portfolios.

Investing for 11-15-Year-Olds

When a child moves into middle school, the portfolio should begin focusing on bond and Treasury ETFs. With roughly five years until the 529 account will begin to be tapped, principal conservation should be the primary goal. Equity ETFs still deserve a place in the 529 plan, but at this point, they should be taking up only about one-third of the total portfolio.

Within the bond portion of the portfolio, investors should be looking for low-cost, shorter-term high investment-grade securities. Government notes are the most conservative, because their principal is backed by the full faith and credit of the government. Corporate bonds don't carry the government guarantee and therefore typically carry a bit higher yield. Again, shorter-term bonds should be the focus, as longer-term bonds with maturities of 10 or more years can actually carry a high degree of risk if interest rates begin rising.

Investing for Children Over 15 Years Old

At this point, college is near. The focus of the 529 portfolio should not be maximizing returns but on preserving the capital that already exists in the account. An allocation of 80 to 90% high-quality bond and money market ETFs is appropriate at this age. While the portfolio at this time won't likely produce any significant returns, it shouldn't produce any significant losses either. That should be the primary consideration, since withdrawals from the 529 plan are imminent.

Conclusion

Each state offers its own menu of options for 529 plans. It's difficult to make specific ETF recommendations; most options won't be available to all investors. The types of ETFs that should be selected for a 529 account should include those with a high degree of diversification and minimal expense ratios. Limiting the expenses paid for funds and ETFs within the plan is one of the best ways to improve the performance of the 529 portfolio over time.

For a younger child, investors can take more risk. As time goes on and the child grows older, the 529 portfolio should gradually turn more conservative to ensure principal preservation. Many plans offer age-based portfolios that automatically turn more conservative over time, and investors should consider these if they don't want to actively manage their accounts.