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Smart Advice for the HuffPost Investor

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Are 529 plans a good way to fund the rapidly escalating costs of higher education?

There are many bad plans, a few good ones and one exceptional one. It is one of the best kept secrets in the investing world. I spill the beans and identify the plan.

A reader has mega returns with only a few hours effort. What does he know that the professional money managers at major fund families haven't figured out?

I address these issues in this week's column.

Thanks for your excellent questions. Please continue to add them as comments to this blog.

Question From Camel54:


Forgive me if you've answered this already or if it is too off-subject. Are there any advantages to using a 529 for a child's college? I know it makes it easy for friends and family to contribute, and it can be transferred to another family member if it isn't used by the intended child. But what about real, significant investment advantages, any? There seem to be such an array of penalties if the investor deviates from a strict usage guideline. Would it make more sense to just invest as you would otherwise and hope there is enough in 18 years to send the little one to Yale?


There are some advantages to funding higher education using a 529 plan.

Contribution limits vary by state but are generally very high ($200,000-$300,000). Appreciation in these accounts is tax free and withdrawals are also tax free, as long as they are used to pay qualified educational expenses.

You are not confined to the 529 Plan in your state, but there may be tax advantages to using that plan.

Here's the rub:

The majority of state plans feature high expense ratio, hyperactively managed funds that are likely to under-perform low cost, index funds over the long term. In addition, some plans have high expenses, including broker commissions and enrollment, annual maintenance, transfer, and advisor fees.

Look for a plan that has low cost index funds from the major fund families like Vanguard.

An excellent resource for comparing costs and investment options of various 529 plans is:

There is one 529 plan that is unique and is worthy of special consideration.

West Virginia offers a "Smart529 Select" plan that features age based portfolios consisting solely of funds managed by Dimensional Fund Advisors (DFA). You just pick from one of the seven portfolios that is designated with the age range of your child.

The asset allocation automatically shifts to a more conservative portfolio as your child gets older. Nothing could be easier.

DFA funds are "passively managed." DFA does not engage in stock picking or market timing. Instead, it captures specific dimensions of risk identified by academic research. It has done so with remarkable success.

Normally, DFA funds are only available through designated Registered Investment Advisors. (Full disclosure: I am one of those advisors. I place the assets of my individual clients and my 401[k] clients in DFA funds). These advisors charge an advisory fee for doing so.

What's the big deal about DFA funds?

Think of DFA as Vanguard index funds on steroids.

In a recently published study, Edward Tower, a Professor of Economics at Duke University, and Cheng-Ying Yang, a masters candidate in economics at Duke, addressed the question of whether the performance of DFA funds compared to Vanguard funds justified paying the advisory fee. There is no advisory fee when buying low cost index funds directly from Vanguard.

The authors looked at data for the period 1999-2006. Here are their startling findings:

* They compared the aggregate performance of DFA's funds with the aggregate performance of Vanguard funds. The DFA funds outperformed the Vanguard funds by a whopping 8.2 percent per year;

* They also compared the Vanguard funds that came as close as possible to duplicating the asset class and style weights of the aggregate DFA funds. Even with this adjustment, DFA outperformed Vanguard by 2.46 percent per year.

The West Virginia 529 plan is an opportunity for investors to get the benefits afforded by DFA funds without paying any advisory fee. You might want to look into it.

Question From: HeresJohnny

Dan, I have to say that I'm not that impressed with your advice. Most people can do just fine by taking a good look at the investments out there and trying to find out where the opportunity is. Fortunately, my employer does a 2-for-1 match. Unfortunately, they also greatly limit the choice of investment vehicles available. Within that constraint, I probably could have invested in an index fund easily and been content with 10-12 percent return. I didn't. It took a few hours of scouring listings, but I eventually went with a fund that is up 60 percent ytd, and 80 percent over the time that I owned it. I think Mark Twain's advice is better: Put all your eggs in one basket, and then WATCH THAT BASKET.


Let me see if I can change your unfavorable impression.

The data indicates that "most people" can't do "just fine" by spending a few hours and picking high performing mutual funds.

Dalbar, Inc., a well respected research firm, looked at the returns of the average mutual fund investor for the 19 year period from January, 1984-December of 2002. What did it find?

The average equity fund investor had returns of only 2.57 percent per year. During this same time, the S & P 500 index had an average return of 12.22 percent per year.

The rate of inflation during this period was 3.14 percent.

When you add taxes, the average investor lost a lot of money! This is not doing "just fine."

What accounts for this poor performance?

Investors, egged on by their "investment professionals," chase returns instead of buying and holding. They are always looking for the next hot fund or the next hot fund manager.

How do we account for your good fortune in selecting a fund you state is up 60 percent YTD?

It is most likely a product of luck and your willingness to take large risks with your assets.

Your few hours of "scouring listings" are not the key to investment success. If it was, how do you explain the fact that less than 1 percent of all mutual funds have achieved your results this year? These are skilled professionals, with huge budgets and an army of analysts, who spend thousands of hours trying to achieve superior returns. Few of them succeed in doing so. Over any 10-year period, less than 5 percent of the many funds that have as a goal beating the S & P 500 index succeed in equaling the returns of that index.

If your fund really is up 60 percent YTD, it is a very volatile fund. When you take big risks, there is always the possibility of a big reward. However, risky investments do not always move in one direction. You should be prepared to watch the eggs in that basket crack open and dribble away.

Your negative views on diversification are sharply contradicted by leading financial minds in this country who have spent their lives studying the capital markets and publishing their findings in peer reviewed financial journals.

The importance of diversifying assets was summarized in one published study by Roger G. Ibbotson and Paul D. Kaplan as follows: "On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation."

William Bernstein, the author of the highly acclaimed book, The Intelligent Asset Allocator, agrees: "The essence of effective portfolio construction is the use of a large number of poorly correlated assets"

There are hundreds of studies that support these views. It is a mistake for investors to rely on their own anecdotal experiences to reach a contrary conclusion.

While I have great admiration for Mark Twain, I would not rely on his investment advice.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.