By Jeff Brown | Contributor for U.S. News & World Report
Sept. 28, 2016, at 9:29 a.m.
If you’re accustomed to investing in mutual funds – the ordinary open-ended variety – you probably know about closed-ended funds and exchange-traded funds. But what about unit investment trusts?
Another twist on the pooled-money strategy, unit investment trusts are for investors who want steady income, transparency and liquidity in holdings selected by professionals.
“UITs are good for investors who want to buy and hold securities and gain interest and reinvest dividends over a certain amount of time,” says JeFreda Brown, CEO of Goshen Business Group in Birmingham, Alabama.
Though many investors have not heard of UITs, there are lots of them: 5,188 trusts with a value of $94.13 billion at the end of 2015, according to the Investment Company Institute, the fund industry’s trade group. So it’s worth knowing how they differ from close relations like open- and closed-ended mutual funds, and exchange-traded funds.
Mutual fund. With an ordinary open-ended mutual fund, your money is pooled with other investors’ money and used to buy bonds or stocks that fit the fund’s investing strategy.
When you buy fund shares, the fund buys more of those holdings, and when you sell, the fund gets rid of some. You or your advisor deal with the fund company, which is always available to take your investment or redeem your shares. Trades are done at the end-of-day price, or net asset value, figured by dividing the value of the fund’s assets by the number of shares outstanding.
Closed-end fund. A CEF is much the same as a mutual fund except that a fixed number of shares are issued when the fund is created, and they are traded like stocks, with prices rising or falling with market conditions. Though the number of fund shares is fixed, the fund’s holdings can change as managers buy and sell.
CEFs can trade at a discount or premium to the net asset value of the fund’s holdings. To get out, you sell to another investor rather than redeeming with the fund issuer.
Exchange-traded fund. An ETF owns a basket of stocks or bonds and is traded like a stock, usually tracking an underlying index like the Standard & Poor’s 500. Unlike a CEF, an ETF has a mechanism for assuring the market price closely tracks the net asset value, minimizing discounts and premiums.
In most cases, the fund’s holdings change only if the underlying index changes its components. Otherwise, there is no active management.
Unit investment trust. UITs are similar to closed-ended funds and are traded on exchanges or bought and sold through the issuer, except that the UIT has a specified lifespan, often one to five years, and its holdings are fixed at the start and do not change. When that period ends, investors – called unit holders – receive a payment based on their share of the assets in the fund, much as one gets principal back when a bond matures.
Like ETFs, UITs, once set up, are passively managed – there is no team of analysts looking for hot stocks or bonds – and the UIT’s holdings stay the same through the life of the fund. Lack of management keeps annual fees low, though some experts warn that brokers can charge hefty sales commissions.
Among the benefits. UITs, unlike open-ended funds, shelter investors from the unwelcome year-end capital gains distributions that can cause tax bills. Because the UIT is not involved in active buying and selling, it does not have realized gains from sales during the year to be distributed at year-end. When you buy a UIT, the year’s gains to that point are already reflected in the unit price, while they may not be reflected in the price paid for an open-ended fund.
Traditionally, UITs holding bonds – especially tax-free municipal bonds – have been more popular than ones holding stocks, but that has changed in recent years with bond yields very low and many investors eager to share stock market gains.
Generally, investors buy and sell through a broker, though prices for some UITs are quoted on the Nasdaq mutual fund quotation service.
“Investors typically purchase UITs for income,” says Sterling D. Neblett, founder of Centurion Wealth Management in McLean, Virginia. “Because the securities held by UITs remain unchanged for a fixed period of time, investors generally are able to determine the income that will be generated.”
Income is usually paid monthly.
Jordan Niefeld, a planner in Aventura, Florida, says UITs offer a simple way to get diversification, and because the portfolio is fixed the investor knows what he owns at all times. And UITs are liquid, since the investor can get in or out at any time.
UIT holdings are listed in offering documents. Because there is no active management, the fund cannot adapt to changing market conditions, so the wise investor must keep track of the portfolio’s risks and returns and know when to get out when conditions sour.
The fixed holding period, while providing predictability, adds another risk, since the unit holder may get his or her money back at a time when prospects for reinvesting are poor. To manage that risk, the unit holder can monitor market conditions and sell early, but that requires more work and savvy than many fund investors are prepared to do.
So UITs offer diversification, liquidity and an unusual amount of transparency and income predictability. But, as a product usually traded through a full-service brokerage, costs can be high. Be sure you are getting top-quality advice in return.
“As a financial advisor, I would never recommend purchasing UITs,” Neblett says.
“UITs are essentially wrapping an extra layer of high fees for an initial selection of investments which aren’t even actively managed throughout the term of the UIT,” he says. “Investors are much better off purchasing the underlying securities directly without the extra layer of fees.”