A Unit Investment Trust (UIT) is an open-ended pooled fund consisting of securities held in it for a specific time. The sponsoring trust entity carefully and strategically chooses the stocks and bonds that would make up the portfolio.
Generally, the UIT’s sponsor does not actively trade the securities but just buy and retain for their returns. Usually, a unit investment trust has an SEC registration as a Registered Investment Company (RIC) or Grantor trust.
Most often, the portfolio stays fixed until the sponsor terminates the trust. This can take anywhere from 13 years to 30 years, depending on the underlying securities. There might be instances when the sponsor may remove a security or two from the trust.
However, they will only do it under limited circumstances, usually to protect the fund. An investor may find these situations in the prospectus or Declaration of Trust.
What is Unit Investment Trust (UIT)?
The UIT follows a financial game plan. It is an investment objective over a specific time period. However, there is no guarantee that the sponsor will meet this objective. The trust sponsor creates the trust by laying down the specific investment terms. They include the trust objective, securities to put into the trust, the period of the trust, schedule of fees, etc. Investors will find these terms in the prospectus.
Some UITs stick to popular rules when choosing the stocks for the portfolio. They choose the securities through a method called ‘back-testing’. It’s a method of applying an investment strategy over a mix of stocks and bonds. The objective is to see the result if the mix was done years before.
How It Works
The hypothetical performance can help investors by showing how the strategy will work at the present time. It is wise to remember that past success does not guarantee future success. The hypothetical performance relies on past performance and the future will always change.
A unit investment trust is technically an investment company. Its fixed portfolio of stocks and bonds become redeemable units to investors over a specific time period. The objective is to increase the capital’s value and/or earn through dividends. Aside from UIT’s, regulators also consider mutual funds and closed-end funds as investment companies.
Types of Unit Investment Trusts
The securities in a UIT determine what type of trust it is. They may be a stock (equity) trust or a bond (fixed-income) trust.
Stock trusts generally provide capital appreciation or income from dividends.
Sponsors usually issue as many units or shares as needed for a limited time before the primary offering period ends. Equity trusts have a definite termination date. On this date, the sponsor liquidates the trust and distributes the proceeds to unit holders. They will use the net asset value as the basis for distribution. The unit holders may choose to receive the money and spend it, as they will. They can also opt to reinvest the proceeds in another UIT.
In a bond trust, the sponsor issues a fixed number of units.
When they sell all the units to investors, they then close the primary offering period. Bond trusts will pay a relatively fixed monthly income to unit holders. This will happen until the first bond matures (or ‘called’ by the bond’s issuer). The sponsor will then distribute the proceeds to the investors upon the redemption of the bond. This is actually a return of principal and the sponsor will allocate the funds pro-rata, according to investors’ principal.
The trust will continue to pay the adjusted monthly income until the next bond reaches its maturity. The pattern will go on until the sponsor redeems all the bonds in the portfolio. As you can see, for people who want current income and a stable principal, a bond trust is ideal.
In recent years, UITs have grown in popularity due to many reasons. One of them is that most of them have primary investment objectives geared towards providing dividend income.
The UITs can select their portfolios to include securities that provide better returns than traditional securities like bonds. These income-producing securities can include the following:
- Closed-end funds (that may or may not employ leverage)
- Preferred stocks
- Real estate investment trust (REIT)
- Business development companies (BDCs)
- Master limited partnerships (MLPs)
- Dividend-paying equities
Features of a UIT
- A UIT usually issues redeemable securities or units. This works similarly like a mutual fund. At the investor’s request, the sponsor will buy back the investor’s units at their net asset value (NAV). Some companies have structured their exchange-traded funds (ETFs) as UITs.
- A UIT will make a one-time “public offering” of a limited set number of units. This is much like what closed-end funds do. However, many UIT sponsors will create a secondary market for the shares. This will let unitholders to sell their units back to the sponsor and allow new investors to purchase units.
- A UIT will have a definite termination date when the trust will end and dissolve. The sponsor will set this date upon the creation of the UIT. Some UITs may carry on for fifty years before the sponsors terminate them. In the case of a UIT that invests in bonds, the bonds’ maturity will be determine termination date. When a UIT terminates, the sponsor will liquidate all remaining investment portfolio securities and distribute the proceeds to unit holders.
- A UIT does not actively trade the securities in its portfolio. What basically happens is that the UIT will buy a generally fixed portfolio of securities. This will be around five, ten or twenty stocks or bonds. The fund will then hold these securities with minimal or zero exchange at all throughout the life of the UIT. Because of the fixed composition of the portfolio, investors will know beforehand, what they are investing in. The UIT will list its portfolio on its prospectus for the benefit of investors.
A UIT will have a sponsor for a fund manager. It does not have a board of directors, corporate officers or investment advisers to provide financial advice during its term.
The UIT can distribute interests and dividends to its investors. When the life of the trust ends, investors can receive cash equal to the net asset value of their units. In some cases, they can receive the payment in kind from the investments held by the trust. They can also opt to roll the current value of their units into another trust fund usually at discounted charges.
UITS have a pre-determined fixed term. For trusts that invest in equities, the life range is an average of two years.
UITs versus Mutual Funds
From many angles, UITs and Mutual Funds look very similar. But when you look closely, there are many distinct differences. Yes, they both have professionally-selected securities in their portfolios. However, UITs maintain a fixed portfolio, not like mutual funds. The sponsors don’t normally change any of the stocks and bonds once they select them.
Since these securities remain the same throughout the term, investors can see what they really own. Investors can usually buy or sell UITs on any business day at the current market price. This price could be greater or lesser than what the investors originally paid for them.
In mutual funds, the fund manager actively trades the securities in the hope of generating more income for the fund. In a UIT, the fund manager selects, buys and holds the securities until maturity.
Buying a UIT is quite different from buying a mutual fund. The management fees of a UIT are lower than the fees for a mutual fund. In a buy-and-hold scheme like in a UIT, there’s not too much ‘management’ involved. There are sales fees attached to UITs. Mutual funds also carry similar fees.
Here’s the difference: investors pay a sales commission to buy a UIT, but not when you sell.
The sponsor of a UIT holds the securities in its portfolio until their maturity dates. This causes the UITs to adopt the same maturity dates. Mutual funds do not carry this maturity feature.
Pros and Cons of a UIT
Advantages of a UIT
Investors prefer UITs to other funds for several reasons. These are:
- They like its diversification. A UIT’s portfolio will normally consist of at least 20 stocks and/or bonds so it provides instant diversification. An investor may buy only one unit – but he gets diversification as well. The investments can also come from a wide variety of issuers, sectors or geographies.
- They appreciate the professional portfolio assembly. We have said that investment professionals carefully select the securities that go into a UIT’s portfolio. This sits well for investors because they know that the portfolio aims to generate good returns.
- They know exactly what they own. Once the investment professional chooses what securities go into the portfolio, they usually don’t change. Investors would know exactly what stocks and bonds they would own. They can also find the securities they are familiar with and buy a UIT that carries them. Many investors would rather work this way.
Disadvantages of a UIT
Now, here’s the other side of the coin:
- Portfolio managers cannot actively manage the securities. This restriction might sometime let some great opportunities pass and therefore miss out on some great deals.
- Investors have to pay special fees. There are fees unique to a UIT. Investors may have to shell out for a sales fee, a one-time organizational cost and some annual charges for trustee or supervisory fees.
Tax impact of the UIT
For the taxation-conscious, UITs offer a shelter from the unrealized capital gains taxes.
This shelter is not available for mutual funds. Sponsors assemble UITs for a specified time. Therefore, the purchase price of the securities serves as the cost basis of the units. For a mutual fund, the basis is different. The government will tax the investor for the entire previous year, irrespective of the actual purchase date.
An investor may purchase a mutual fund in October and absorbs a loss in that quarter. Still, the government will tax the investor for capital gains of the underlying securities from January 1 of the year. A UIT avoids this tax consequence because it assembles a new ‘investment’ for each individual investor.
Several exchange-traded funds are technically UITs. However, ETFs do not normally have set portfolios. The fund manager administers it or updates it to automatically follow an index. It can have a lifetime of up to over 100 years. For example, according to their prospectus, the SPDR S&P 500 ETF Trust has a mandatory termination date of January 21, 2118.[i] Also from their prospectus, the PowerShares QQQ Trust will terminate on March 4, 2124.[ii]
[i] www.spdrs.com/library-content/public/SPY%20Prospectus.pdf, (archived), accessed Oct. 18, 2017
[ii] http://hosted.rightprospectus.com/PowerShares/Fund.aspx?cu=73935A104&dt=P&ss=etf, accessed Oct. 18, 2017