For Sale: College savings plan. Includes leverage, derivatives, mortgage-backed securities

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Morningstar, which is one of the biggest mutual fund trackers, came out with its annual review of the best and worst 529 plans today. 529 plans are tax-advantaged investing accounts to save for college expenses. Some states let you take a write-off for contributions. Your earnings grow tax-free, and your withdrawals aren’t subject to federal income tax. It’s a good deal, and one of the best for college savings. You don’t have to invest in your own state’s account, but most people do, since most states only give you the tax break if you invest in its own account. graduation-by-sara-haj-hassan

Each state partners with two or three mutual fund managers, and investors in that state’s plan must choose from the variety of mutual funds offered. The funds include your run-of-the-mill index funds and a smattering of actively managed funds, depending on the state. While under a different name, many of the funds offered are similar to target-date retirement funds. You give them your kid’s age or when he’ll matriculate, and the fund will become more conservative as the date comes closer.

Sounds easy, right? Well, what if your state picks a real stinker of a mutual fund manager?

Such was the case with the five states that chose OppenheimerFunds to manage some of their savings plans. Investors in the Oppenheimer funds might have been allocated properly between stocks and bonds. But the actively-managed bond fund that Oppenheimer allocated them to lost more than 35% in 2008.

Now, the average bond fund was down only about 4.7% last year. What in the hell were Oppenheimer’s bond managers doing? According to Morningstar, “management gained exposure to the battered commercial mortgage-backed securities market through derivatives that had a leveraging effect on the fund, amplifying losses.”

“Mortgage-backed securities,” “derivatives,” and “leveraging” are three words that I would never want to see attached to my child’s college savings plan. What’s even worse, the fund managers were upping their stake in mortgage-backed securities in 2008, even as the market had started to fall apart.

Almost laughably, the Oppenheimer Limited-Term Government bond fund and U.S. Government bond fund also experienced losses even though U.S. government-backed bonds were pretty much the only asset class last year to make money. The reason? Oppenheimer made bets on non-government, mortgage-backed securities in those funds too!

Some states, like Illinois and Oregon, plan to file or have filed lawsuits against Oppenheimer. I say, it’s too little, too late. The last couple years have shown that every investor needs to pay extremely close attention to what his fund is invested in. But if a state is going to attach its name to a fund, and even restrict its state’s residents to investing in certain funds, state officials better pay attention to how the fund managers invest the money before something like this happens.

If you’re deciding between 529s right now, keep in mind that you don’t have to invest in your own state’s plan, though you may lose a tax break if you don’t. Nearly every plan will also let you choose between fund managers and fund styles. (Illinois’ college savers could have chosen Vanguard funds, for example.) For this category of investing especially, I would stick with index funds with low fees and have a relatively low amount of money allocated to stocks. Unless you’re saving for your kid’s college tuition before he or she is born, there’s just too short of an investment window to take big risks.

Savingforcollege.com is a great resource to research and choose 529 plans. Just make sure you get the mutual fund prospectus also.

– Joe Light

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