Unit Investment Trusts -by John Jastremski

Despite offering certain distinct advantages for an investor, unit investment trusts (UITs) are not nearly as familiar to most people as, say, mutual funds. According to data compiled by the Investment Company Institute (ICI), in 2013 mutual funds held roughly 173 times as much money as all UITs did. But as a greater diversity of UITs have been introduced, they have become more popular as an investment vehicle.

Historically, most unit investment trusts have invested in bonds, especially municipal bonds. However, in recent years, equity UITs have taken the lead.

What is a unit investment trust?

Like a mutual fund, a UIT represents a collection of individual securities. However, unlike a mutual fund, it has a specified termination date. A UIT can last as little as a year, or 30 years or more. A bond UIT’s termination date coincides with the maturity dates of the bonds it holds; an equity UIT specifies its termination date. Once that date is reached, the proceeds are either distributed to investors or, in some cases, reinvested in another trust.

When a UIT is launched, it buys a collection of securities that typically does not change throughout the life of the trust. By comparison, the portfolio manager of an actively managed mutual fund may buy and sell individual securities at any time based on his or her judgment about their prospects. Also, a UIT is free to hold only a handful of securities; most mutual funds are required to have far more individual holdings to achieve a minimum required level of diversification. In some cases, a UIT will invest in a particular subset of an index, hoping to outperform the index itself.

Once a UIT is launched, UIT sponsors are required to buy back an investor’s shares at their net asset value, which is based on the market value of the UIT’s individual holdings. Some also maintain a secondary market that enables investors to purchase UIT shares that have been redeemed by other owners.

A UIT is an easy way to diversify, particularly in the case of bonds. Though it’s not impossible to assemble a well-diversified portfolio of individual securities, the minimum investment required by each individual bond means that achieving the appropriate level of diversification can require a substantial investment.

Advantages of a UIT

Relative certainty about specific holdings

With a UIT, you know the specific securities in which you’re investing at all times; a list of them must be included in the UIT’s prospectus. With an actively managed mutual fund, you’re relying on the portfolio manager’s expertise in trading and securities selection, and the fund’s holdings may change depending on the manager’s view of what is likely to be most profitable. Knowing exactly what’s in your UIT gives you a greater ability to tailor your other holdings accordingly.

A UIT also can be a way to avoid overweighting a particular security in your portfolio. For example, let’s say your employer represents a substantial part of the S&P 500, and you’ve accumulated many shares of its stock as part of your compensation. Investing in an S&P 500 index mutual fund would automatically add to your holdings of company stock, potentially leaving you with an inappropriate overweighting. A UIT’s transparency can help you avoid being too heavily concentrated in a single security.

The stability of a UIT’s holdings allows you to gauge more precisely whether a specific UIT is appropriate for your individual situation and risk tolerance. In the case of a bond fund, it also can mean greater reliability of income; unless an issuer defaults or calls a bond, the income stream from a UIT is likely to be relatively predictable over the life of the fund. (Remember, however, that a UIT’s total return is based not only on interest but also on the market value of the UIT’s holdings, which can vary.)

Professional securities selection

A UIT’s holdings are chosen by a professional money manager and designed to further a particular investment objective. That factor is especially important with a UIT. Because the securities themselves don’t change over the life of the trust, it represents a classic “buy-and-hold” strategy, so the selection of specific securities is critical.

Ease of focusing on a specific strategy or sector

UITs can be an easy way to concentrate on a market sector or implement a specific investing strategy. For example, one-year UITs that pursued the “Dogs of the Dow” strategy–buying the 10 Dow Industrial stocks with the highest yields at the beginning of the year and then replacing them at the end of the year–were some of the earliest equity UITs. Also, because a UIT is free to invest in a very limited number of securities, it can focus on what the trust’s sponsors consider the best investing ideas, without having to include lesser prospects simply to achieve a certain diversification level.

Cost efficiencies

Because a trust doesn’t trade frequently, it avoids much of the trading costs incurred by investors in a mutual fund with a high turnover ratio. Infrequent or nonexistent trading also means that a trust typically has little or no portfolio management fees. And because a UIT does not generally market shares to the public after the initial offering, UITs generally do not charge the ongoing marketing fees that many mutual funds do. Finally, because UITs don’t have to hold a large cash position to take care of unitholder redemptions, more of your investment is free to be put to work.

Tax advantages

Because it doesn’t trade frequently, a UIT is unlikely to generate much capital gains liability from year to year. By contrast, a mutual fund that has realized capital gains is required to distribute those to shareholders each year; that can create a tax liability for the fund’s shareholders. For example, if a mutual fund is forced to sell shares to meet shareholder redemptions, the fund might realize capital gains that are taxable to you even if the fund has lost money. A UIT generally doesn’t have to sell securities to meet investor redemptions, and therefore doesn’t incur capital gains liabilities to pass on to unitholders.

Factors to be aware of

Purchasing a UIT may involve sales charges

Before investing in a UIT, you should understand how much you’re paying to do so. Find out how much of your purchase represents any initial sales charge, or whether a deferred sales charge will be imposed when you sell your units. Also, find out whether purchasing more units would qualify you for a discount on any sales charges; in many cases, if you purchase more than a certain amount–what’s known as a breakpoint–the sales charge percentage may be reduced.

Gauging performance can be challenging

A UIT that represents a unique selection of securities may be difficult to compare to an appropriate benchmark in order to gauge its performance, particularly if the UIT is newly launched. A UIT’s sponsor may provide performance data based on backtesting a particular time frame or strategy, using historical data to gauge how the UIT’s holdings would have performed in the past. However, past performance is no guarantee of future results, and your UIT’s performance could be very different.

A limited number of investments means less diversification

As stated earlier, a UIT is free to focus on a limited number of securities; for example, a UIT might invest in the 20 securities in the S&P 500 that have had the highest yields over the last 10 years. However, that concentration means that if one of those 20 companies runs into trouble, it will have a greater impact on the value of your investment than if you were invested in all 500 S&P stocks. Remember that you’re generally married to a UIT’s specific investments as long as you hold your units. If the value of those holdings plummets, you not only would suffer from that loss in value but also might have difficulty selling your shares on the open market, as many holders of Internet UITs found out when the tech bubble burst.

The value of your investment can fluctuate

Even though your UIT’s holdings won’t change, their value can fluctuate. As a result, your UIT’s units may or may not be worth what you paid for them when the UIT reaches its termination date. That’s particularly true for equity UITs; a bond UIT’s sensitivity to interest rate changes declines as it nears its termination date.

 

 

 

 

 

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of John Jastremski, and The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

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John Jastremski is a Representative with FSC Securities and may be reached at www.theretirementgroup.com.

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