When you beganyour investing journey, you might have come across something known as a UIT, or Unit Investment Trust.This overview will walk you through some of the basics, so you have a good working knowledge of what UITs are, how they are put together, and why they were such a mainstay of investor portfolios for so many generations.
What Isa Unit Investment Trust?
Like a mutual fund, a unit investment trust is registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940. AUIT differs from a mutual fund in that it consistsof a basket of passively held stocks, bonds, mortgages,REITs, MLPs,preferred stocks, or other securities put together by aninvestment bank,brokerage firm, wealth management company, or sponsor thatraised money from investors to construct the portfolioin accordance withthe guidelines spelled out in alegal document called the Trust Indenture.
Sometimes, the selection is made quantitatively.Sometimes it is made qualitatively.In rarer cases, it is a combination.For example, one UIT might consist of a basket ofblue-chip stocksthat have raiseddividendpayouts every year for at least 25 years and have a certain minimummarket capitalizationsize.Another might be made up of biotechnology stocks headquartered within the United States.Still, another might invest solely incorporate bondsissued by companies operating within a certainsector or industry.The unit investment trust owner receives the units and collects the income produced by the holdings until the trust dissolves.
Once formed, the UIT is essentially "dead money" in that there is no on-going active management.It keeps turnover and costs lower than many actively managed funds.
UIT Expiration Dates
One wrinkle new investors have when encountering unit investment trusts is discovering that they have expiration dates.Upon expiration, the trust dissolves.The owner typically has one of three choices:
- Take delivery of the underlying assets (known as an "in-kind" delivery).That is, you get your share of all of the stocks, bonds, REITs, or other holdings in the trusttransferred to your name.For most people, this would mean depositing them in a brokerage account or having them directly registered to take advantage of theDRIPs.
- Rollover the trust into a new similar, identical, or different unit investment trust offered by the sponsor.Many times, sponsors will offer incentives to do so, frequently in the form of a lower sales charge or another fee arrangement.
- Take cash liquidation value at the termination of the trust when the underlying holdings are sold or, in the case of bonds, matured.
UIT Structures
Currentlaw allowsunit investment trusts to be structured in one of two ways.The first is known as a grantor trust, which gives the unit-holder proportional ownership in the actual underlying basket of securities.
The second is a "regulated investment company," in which the unit-holder owns the trust, partnership, or corporation (depending upon the exact legal structure used to facilitate the offering) that, in turn, owns the basket of securities.
From a practical standpoint, there isn't much difference to the investor, but it's important to study the regulatory filings to know precisely whichtype you have acquired and if you are comfortable with its structure and risks.Some modern unit investment trusts are sold asExchange Traded Funds or ETFs.
How Popular Are They?
In many ways, unit investment trusts were one of the earliest forms of a mutual funddespite having a distinctly different legal structure.As surprising as it might seem, it wasn't that long ago that unit investment trusts outnumbered mutual funds.
According toInvestment Company Institute, unit investment trusts outnumbered mutual funds 13,310 to 5,325 as recently as 1994.
In 2012, the Investment Company Institute reported that there were 5,787 trusts, of which 2,426 were equity (stock) trusts, 533 were taxable bond trusts, and 2,808 weretax-free bondtrusts. UITs had experienced a resurgence of sorts between 2008 and 2012 when total assets stood at$71.73 million—a figure that had more than doubled during the period as a result of interest rates going to zero and many investors casting a longing eye toward the investment vehicle because many sponsors prioritizepassive incomewhen putting together a new offering.
Regardless of the recent renaissance, the $71.73 million in UITs is dwarfed by the trillions of dollars in ordinary mutual funds andindex funds.
Advantages
One of the primary advantages of UITs has to do with the waycapital gains taxesare treated.With a traditional mutual fund, it is possible to experience a loss on your investment while being hit with taxes on someone else's capital gains; capital gains that you never enjoyed. It can be a realproblem for certain value-oriented, long-term,buy-and-hold strategyfunds that are sitting on highly appreciated securities soldduring a year prior to the current investor acquiring the fund shares.
This doesn't matter if you invest in the mutual fund through a tax shelter such as aRoth IRAorRoth 401(k), but it can be a real problem if you buy directly or through a regularbrokerage account.The issuedoesn't occur with a unit investment trust becausethe sponsor packages together the securities at the time the order is placed, meaning the cost basis for the underlying holdings is unique to the original purchaser.
Disadvantages
When the unit investment trust collects dividends and/or interestfrom the underlying securities, it then pays the cashout to the owner.However, unlike a traditionalopen-ended mutual fund, it's not possible to immediately reinvest these cash flows back into the trust itself due to the way it is structured (recall that the UIT is a fixed portfolio of preselected securities).
It means in rising markets, a so-called "cash drag" can develop whereby the returns are slightly less than they otherwise would have been had the exact same portfolio been owned either outright or through a regular mutual fund.This isn't always a bad thing because, in down markets, it works the other way.
Another potential downfall of unit investment trusts is the cost at the time of acquisition.I've seen UITs focused on portfolios of utility stocks that expire within a year or two of creation and charge a 2.95% sales load on purchases of $50,000 or less.
That's not as bad as it sounds when you consider that unlike a mutual fund charging a comparable sales load, there is nomutual fund expense ratioandyou can take delivery of the stocks upon trust termination; the sales load servingas a de facto commission on 50 to 100 positions, making it reasonable.Still, if you know the holdings you want, it's often going to be cheaper to assemble them yourself by purchasing stocks outright.
