When you start your investment journey, you may have come across something known as a unit investment trust or “UIT”. This overview will provide you with some basic principles so that you have a good understanding of what unit investment trusts are, how they are structured, and why they have been a core part of investors’ portfolios for generations.
What is a Unit Investment Trust?
Like mutual funds, a unit investment trust is registered with the U.S. Securities and Exchange Commission under the Investment Company Act of 1940. A unit investment trust differs from a mutual fund in that it consists of a fixed portfolio of stocks, bonds, mortgages, real estate investment trusts, limited liability companies, preferred stocks, or other securities that are assembled by an investment bank, brokerage firm, wealth management company, or sponsor that raised capital from investors to create the portfolio according to principles specified in a legal document called the trust indenture.
Expiration Dates of Unit Investment Trusts
One detail that new investors encounter when dealing with unit investment trusts is discovering that they have expiration dates. When a trust expires, it is dissolved. Typically, the owner has one of three options:
- Receive the underlying assets (known as “in-kind distribution”). That is, you receive your share of all the stocks, bonds, real estate investment trusts, or other assets in the trust and transfer them into your name. For most people, this would mean depositing them into a brokerage account or registering them directly to benefit from DRIPs.
- Transfer the trust into a similar or different unit investment trust offered by the sponsor. Often, sponsors will provide incentives to do so, usually in the form of lower sale fees or some other fee arrangement.
- Receive the cash liquidation value when the trust terminates upon the sale of the underlying assets or, in the case of bonds, their maturity.
Structures of Unit Investment Trusts
The current law allows for the structuring of unit investment trusts in two ways. The first is known as a grantor trust, which gives the owner proportionate ownership rights in the actual underlying basket of securities.
The second is an “organized investment company,” where the owner holds the trust, partnership, or corporation (depending on the exact legal structure used to facilitate the offering) that in turn owns the basket of securities.
In practice, there’s not much difference to the investor, but it is important to study the regulatory disclosures to know which type you have acquired and whether you are comfortable with its structure and associated risks. Some modern unit investment trusts are sold as exchange-traded funds or ETFs.
The Popularity of Unit Investment Trusts
In many ways, unit investment trusts have been one of the oldest forms of investment funds despite having a completely different legal structure. Although it may seem surprising, it has not been long since unit investment trusts surpassed mutual funds in number.
According to the Investment Company Institute, unit investment trusts surpassed mutual funds 13,310 to 5,325 in 1994. In 2012, the Investment Company Institute reported that there were 5,787 trusts, including 2,426 equity trusts, 533 taxable bond trusts, and 2,808 tax-exempt bond trusts. Unit investment trusts experienced a qualitative resurgence between 2008 and 2012 when total assets reached $71.73 million – a figure that more than doubled during the period as interest rates dropped to zero and many investors turned to this investment vehicle as many sponsors prioritized passive income when setting up new offerings.
Regardless of the recent resurgence, the $71.73 million in unit investment trusts pales in comparison to the trillions of dollars in regular mutual funds and index funds.
Advantages
One of
The main advantages of unit investment trusts relate to the way capital gains taxes are handled. With a traditional mutual fund, you may experience a loss on your investment while paying taxes on capital gains that someone else realized; capital gains that you never enjoyed. This can be a real issue for funds with a value-oriented and long-term strategy, and buy-and-hold strategies that rely on high-value securities that were sold during the previous year before the current investor acquired shares in the fund.
This doesn’t matter if you invested in a mutual fund through a tax shelter like a Roth IRA or Roth 401(k), but it can be a significant issue if you bought directly or through a regular brokerage account. This issue does not occur with a unit investment trust because the sponsor pools the securities together at the time the trust is established, meaning that the cost basis of the underlying assets is unique to the original buyer.
Disadvantages
When a unit investment trust collects dividends and/or interest from the underlying securities, it pays cash to the owner. However, unlike a traditional open-end mutual fund, these cash flows cannot be directly reinvested into the trust itself due to its organizational structure (remember that a unit investment trust is a fixed portfolio of pre-selected securities).
This means that in rising markets, there can be what is known as a “cash drag” where the returns are slightly lower than they would have been if the portfolio itself were held either directly or through a regular mutual fund. This is not always a bad thing because in declining markets, the opposite is true.
Another potential drawback of unit investment trusts is the transaction cost at the time of acquisition. I have seen unit investment trusts focusing on service stock portfolios that terminate within two years of creation and charge a 2.95% sales fee on purchases of $50,000 or less.
This isn’t as bad as it appears when you consider that unlike a mutual fund that charges a sales fee relatively, there is no unit investment trust expense ratio, and you can receive shares when the trust ends; the sales fee acts as an actual commission on 50 to 100 positions, making it reasonable. However, if you know the assets you want, it is likely to be cheaper to accumulate them yourself by purchasing the stocks directly.
Source: https://www.thebalancemoney.com/unit-investment-trust-basics-for-new-investors-357491
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