Unit Investment Trust Basics for New Investors
UITs Are Pre-Constructed Portfolios of Passively Held Securities
When you began your 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 Is a 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. A UIT differs from a mutual fund in that it consists of a basket of passively held stocks, bonds, mortgages, REITs, MLPs, preferred stocks, or other securities put together by an investment bank, brokerage firm, wealth management company, or sponsor that raised money from investors to construct the portfolio in accordance with the guidelines spelled out in a legal 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 of blue-chip stocks that have raised dividend payouts every year for at least 25 years and have a certain minimum market capitalization size. Another might be made up of biotechnology stocks headquartered within the United States. Still, another might invest solely in corporate bonds issued by companies operating within a certain sector 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.
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 trust transferred to your name. For most people, this would mean depositing them in a brokerage account or having them directly registered to take advantage of the DRIPs.
- 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 other 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.
Current law allows unit investment trusts to be structured in one of two ways. The first is known as a "grantor trust," which gives the unit holder a proportional ownership in the actual underlying basket of securities. The second is a "regulated investment company," in which the unitholder 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 which type you have acquired and if you are comfortable with its structure and risks.
Some modern unit investment trusts are sold as Exchange Traded Funds or ETFs.
How Popular Are They?
In many ways, unit investment trusts were one of earliest forms of a mutual fund despite 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 to an article called published in The Wall Street Journal, unit investment trusts outnumbered mutual funds 13,310 to 5,330 as recently as 1994. As of only a few years ago, 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 were tax-free bond trusts.
UITs had experienced a resurgence of sorts between 2008 and 2012 when total assets stood at $71.73 billion; 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 prioritize passive income when putting together a new offering. Regardless of the recent renaissance, the $71.73 billion in UITs is dwarfed by the trillions of dollars in ordinary mutual funds and index funds.
One of the primary advantages of UITs has to do with the way capital gains taxes are 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 real problem for certain value-oriented, long-term, buy-and-hold strategy funds that are sitting on highly appreciated securities sold during 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 a Roth IRA or Roth 401(k), but it can be a real problem if you buy direct or through a regular brokerage account.
The issue doesn't occur with a unit investment trust because the 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.
When the unit investment trust collects dividends and/or interest from the underlying securities, it then pays the cash out to the owner. However, unlike a traditional open-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 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 no mutual fund expense ratio and you can take delivery of the stocks upon trust termination; the sales load serving as 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.