Thursday, March 8, 2012

Stars Can Help Guide College Savers

This article, written by researcher Laura Pavlenko Lutton, from the independent mutual fund rating company Morningstar, shines the light on New Jersey's 529 Plan administered by Franklin Templeton Investments. I thought clients invested in this 529 Plan would enjoy reading it.

By Laura Pavlenko Lutton

Studying 529 plans’ average Morningstar Rating shows which states have done best.

College savers in search of a 529 plan undoubtedly want high-quality investment choices. One way to stack plans up against one another is to study past risk-adjusted returns over longer time periods.

The Morningstar Rating, which compares risk-adjusted returns of investments in the same category, is designed to put past performance in context. Mutual funds, as well as 529 investment options, earn 3-star Morningstar Ratings if their risk-adjusted returns are in the middle of the category pack. Similarly, 4-star and 5-star investments have outperformed, while 2-star and 1-star investments have underperformed. The Morningstar Rating is distributed on a bell curve, with the largest subset of funds earning 3 stars.

Morningstar studied how well 529 plans’ investments have performed historically as measured by the overall Morningstar Rating. Morningstar calculated an asset-weighted average Morningstar Rating for each plan, so within each plan, the largest investment options by asset size carry more weight in the calculation.

Only five 529 plans had an average asset-weighted Morningstar Rating of 4 stars or higher, indicating that most of those plans’ assets meaningfully outperformed similar peers on a risk-adjusted basis. But more than a third of all 529 plans had competitive performance or better, posting an asset-weighted average Morningstar Rating of 3 stars or higher. Morningstar wasn’t able to execute this calculation on more than a dozen plans because their investment options aren’t yet three years old, the minimum performance period required to receive a Morningstar Rating.

Topping the list is a New Jersey-based plan, Franklin Templeton 529 College Savings Plan, with 4.56 stars on average across the plan on an asset weighted basis. This advisor-sold plan is an expanded version of New Jersey’s direct-sold 529 plan, NJBEST 529 College Savings Plan, which averaged 4.06 stars. Performance at these Franklin plans was relatively strong in recent years, though some of that relative success has waned during the recent market volatility. Another top plan was Florida College Investment Plan, which features investment options run by a variety of asset managers.

Interestingly, several of the top-rated plans include primarily indexed funds, which theoretically should turn in returns near the category average. The Vanguard 529 College Savings Plan, New York’s 529 Program (Direct), and Utah Educational Savings Plan each feature primarily Vanguard indexed investment options and have assetweighted, planwide average Morningstar Ratings of 3.72 stars or higher. These 529 plan investment options are among the industry’s cheapest, which gives them a big leg up on their actively managed competition.

Plans with higher asset-weighted average Morningstar Ratings should be proud of their past success, but this backward look at performance is no guarantee of future results. What’s more, the peer groups used to determine the 529 investment options’ Morningstar Ratings have some notable quirks.

For one, 529 category peers often represent a wider range of investment styles than one might see in the similar open-end mutual fund categories. That’s because there are fewer 529 categories, particularly for investments with unusual strategies. For example, there is no stand-alone 529 category for investment options that primarily hold convertible securities or REITs—those options are lumped into diversified equity categories for 529 investment options. By including such outliers in Morningstar’s 529 categories, the peer groups have a broader distribution of returns, which ultimately can impact an investment option’s Morningstar Rating.

Another factor to consider is the rate of change within 529 plans. Most plans that have underperformed for a time—and therefore may have a lower average Morningstar Rating—either got a face-lift or have been completely rebuilt. The plans may not be able to erase poor past performance from their records, but it also would be unfair to expect a revamped plan to perform similarly going forward. This is the case for plans such as the Bright Start College Savings Plans in Illinois and the Oregon College Savings Plan. Ohio took a different tack when its advisor-sold plan, formerly run by Putnam, had poor performance. It added an entirely new plan run by BlackRock and merged the Putnam run assets (thus erasing Putnam’s record) into the new plan when Putnam’s contract with the state expired.

Article written by Laura Pavlenko Lutton, who is an editorial director in Morningstar’s fund research group.