Close

    Offbeat Offerings: Unit Investment Trusts

    by Cara Scatizzi

    Offbeat Offerings: Unit Investment Trusts Splash image

    A unit investment trust (UIT) is an investment vehicle that offers an unmanaged portfolio of securities. Investors buy “units” in the trust and receive a share of principal and dividends.

    How It Works

    A unit investment trust is made up of an unchanging basket of securities. The specific securities are chosen based on stated investment objectives. The securities held in a unit investment trust are not managed, meaning the securities that are selected originally are held throughout the life of the trust.

    The termination date of a unit investment trust varies, depending on the investment objective. A unit investment trust holding long-term bonds may have a termination date of 20 to 30 years from its inception, while a unit investment trust with common stocks may seek to capture shorter-term capital gains from price appreciation over a shorter timeframe.

    Investors buy units of the trust and receive a share of the dividends or interest, as well as proceeds at termination when the trust is dissolved. Some exchange-traded funds (including Diamonds and SPDRs), are organized as unit investment trusts. However, most unit investment trusts are traded through the registered representatives of the unit investment trust sponsors or financial advisers and broker-dealer sponsors who sell the trusts of independent sponsors.

    Unit investment trusts are subject to the same rules and regulations as open- and closed-end mutual funds. Unit investment trusts must produce a prospectus that details investment objectives, performance, sales fees, expenses and the portfolio’s holdings. Annual reports with audited financial statements and performance results are also required by law.

    The typical unit investment trust has a minimum initial investment of $1,000, although for IRAs the minimum often is less. These trusts also typically charge a load at the time of purchase as well as a sales charge. Unit investment trusts also charge an annual fee to cover operating costs. Unit investment trusts do not charge management fees, since the portfolio is not actively managed and transaction costs are kept to a minimum with little or no trading.

    Types

    There are two main types of unit investment trusts: fixed-income and equity. A variety of unit investment trusts exists in these broad categories varying by investment objectives, risk and more.

    Historically, unit investment trusts invest in fixed-income securities—and for tax reasons, usually in municipal bonds—but equity unit investment trusts have been gaining popularity recently.

    A fixed-income unit investment trust can invest in international, corporate, municipal, and government bonds and even mortgage-backed securities. Similar to investing in individual bonds, each type carries its own level of risk and tax issues. International bond unit investment trusts provide access to a market that is difficult for the average investor to participate in. These trusts are denominated in foreign currencies and have added exchange rate conversion risk.

    Equity unit investment trusts are typically structured to follow a stock index. Some are focused on sectors such as healthcare, energy, technology and real estate, while others follow a broad market index. Investment objectives for equity unit investment trusts can range from conservative to aggressive and can have a growth or income bent.

    There are a few differences between the structure of fixed-income and equity unit investment trusts. Investors in fixed-income unit investment trusts will receive regular income from interest, usually monthly; investors who hold bonds directly receive income semiannually or annually. Equity unit investment trust investors may receive income from dividends monthly, quarterly or semiannually.

    Fixed-income unit investment trusts generally allow investors to reinvest income automatically into a mutual fund that holds similar securities or in another unit investment trust. On the other hand, equity unit investment trusts typically allow investors to reinvest in additional units of the same unit investment trust.

    How to Trade

    Price quotes for any unit investment trust can be obtained by a broker or investment firm. NASDAQ’s Mutual Fund Quotation Service also lists price quotes for some, but not all, unit investment trusts. Barron’s also lists prices of some unit investment trusts weekly.

    Units can be purchased through a unit investment trust sponsor, broker or investment firm. Only a limited number of unit investment trusts are sold in an initial public offering (IPO), but many trusts maintain a secondary market for investors. The firm will buy units back from one investor and sell them to another.

    Units of a unit investment trust are typically held until dissolution, but investors have the ability to sell the shares, even in the absence of a secondary market. Trusts are required by law to repurchase outstanding units at the net asset value price, which may be very close to the initial purchase price. Some unit investment trusts allow investors to exchange units from one trust to another.

    Investor Suitability

    A unit investment trust, like a mutual fund, allows investors to hold a diversified investment when it would otherwise be impossible to own a similar basket by investing in the securities themselves. Fixed-income unit investment trusts generally have the same risk as the underlying securities they are invested in, with shorter maturities fluctuating less than longer-term maturities when interest rates change. Equity unit investment trusts will carry more volatility risk than fixed-income unit investment trusts, but have the potential for greater reward. Investors in a high tax bracket may find that investing in tax-free municipal bond unit investment trusts carries the potential for higher aftertax returns compared to investing in taxable bond portfolios.

    Tax Consequences

    Unitholders must pay taxes on dividends, interest and capital gains received unless the unit investment trust is held in a tax-deferred retirement account. In that case, the taxes are deferred until the distributions are taken from the account.

    If units are sold, capital gains or losses must be reported. Municipal unit investment trusts can provide income that is not subject to federal and/or state taxes based on the types of bonds held in the trust.

    The Pros

    Diversification
    Like mutual funds, unit investment trusts provide investors with the ability to diversify their investments, compared to the purchase of individual securities.

    Safety
    Fixed-income unit investment trusts offer the diversification of a basket of securities, and are therefore safer than direct investment in individual securities. In addition, because of the fixed nature of the portfolio holdings, a bond unit investment trust is more similar to holding an individual bond, with a specific maturity, compared to a bond mutual fund. Unit investment trusts themselves are as risky as the underlying security.

    Choices
    There are a wide variety of unit investment trusts for investors to choose from based on the types of securities held.

    The Cons

    Liquidity
    Depending on the type of unit investment trust, it can be more difficult to sell quickly.

    Risk
    Equity unit investment trusts can be as risky as investing in the actual stock market. The unit investment trust’s value will move with the overall market and is not guaranteed to increase in value.

    Additional Information

    Investment Company Institute
    www.ici.org
    The Investment Company Institute (ICI) is the national association of U.S. investment companies. The ICI’s Web site includes a Guide to Unit Investment Trusts that can be viewed on-line or downloaded as a PDF.

    U.S. Securities and Exchange Commission (SEC)
    www.sec.gov
    The SEC provides information about various investments including unit investment trusts. At the home page, choose “more” from the Investor Information category. In the search box, search for “unit investment trusts” to find a short review.


    By Cara Scatizzi
    AAII Associate Financial Analyst


→ Cara Scatizzi