Yahoo Finance Index Funds Offer College Savings Options
When Will Worthwine started putting money away in a 529 plan, a college savings account with tax advantages, his daughter was a freshman in high school.
The Boise, Idaho, dad wanted a pot of money that would be specifically earmarked for college, not to be touched for other purposes. He also wanted a hands-off approach, so he chose portfolios in IDeal, Idaho's 529 plan, largely made up of index funds.
"Index funds are the way to go for someone who does not want to track investments daily," he says.
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Index funds are a basket of securities designed to track a particular market, such as the Standard & Poor's 500 Index, an index of the 500 largest U.S. companies listed on the New York Stock Exchange. There are indices for all types of markets: large and small companies , bonds and international markets, among others.
They are a popular choice because of their low cost and broad market exposure, but investors need to consider their own investment philosophy. Most 529 plans offer both passive investment options -- index funds -- and active options, which use managers who actively seek winning stocks and bonds.
"It comes down to personal choice," says Vivian Tsai, senior director at TIAA-CREF Tuition Financing, Inc. "When you're paying a higher active management fee, generally you believe in the strength of that money manager and their philosophy over time. You believe the return is going to outweigh that additional cost."
Because index funds are not actively managed, they tend to have lower fees than portfolios with managers who pick and choose particular stocks and bonds. Index funds generally will not outperform the market but will ideally mirror it, which has historically gone up over time.
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"What people like about index funds is they are not generally actively managed, meaning that you're not buying and selling securities on a daily basis," says Tsai. "That means it's cheaper for the investor. There are fewer transaction costs. There are lower costs in general."
Index funds are an option in most 529 plans. Some plans -- such as ScholarShare, California's 529 College Savings Plan, managed by TIAA-CREF -- give investors a choice of a passively managed , age-based portfolio that uses index funds or an actively managed age-based portfolio. Age-based portfolios shift assets from stocks to safer investments as the child nears college.
Other plans may not offer that choice but will offer index funds as an option in static portfolios, which do not change over time.
The fee difference between index funds and actively managed funds is "meaningful," says Leo Acheson, senior analyst on the manager research team at Morningstar, Inc., a financial research firm.
The average fee for a primarily actively managed , age-based track within a direct sold plan is about 80 basis points. That means it will cost investors 80 cents for every $100 they invest. The average fee for a similar plan that uses primarily passive investments instead is about 30 basis points, meaning it will cost investors 30 cents for every $100, he says.
"The hope would be that you select a good active manager that is able to outperform the index over the long term," says Acheson. "Usually they come with higher fees, so they have to overcome the fee hurdle."
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Within the ScholarShare program, index funds are the more popular choice, Tsai says -- 50 percent of program assets are in the age-based index offering, while 22 percent are in the active age-based offering.
That doesn't mean actively managed portfolios are not a good bet ; it just means investors should do their homework. Morningstar, which rates 529 plans, has high expectations for some actively managed plans, Acheson says.
"The majority of active managers are not outperforming index funds, but there are plenty of actively managed funds , which we expect to outperform over the long term," he says.
Worthwine says he's been happy with the largely index-driven portfolios he chose within his Idaho plan, which is managed by Ascensus College Savings and offers Vanguard index funds.
Even after getting a late start and contributing "relative small amounts," he estimates he was able to pay for at least half of his daughter's college education at the University of Idaho. Now that she has graduated , he says there is still money in the 529 to help with a master's degree that she will start later this year.
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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