How Do Unit Trusts Work?

Unit trusts are sold by financial advisers or comissioned stock brokers.

Unit trusts are sold by financial advisers or comissioned stock brokers.

Unit investment trusts are the poor stepchild of the investment company universe. While mutual funds, exchange-traded funds and even closed-end funds draw investor interest and dollars, UITs remain a mystery to many investors. Yet the right unit trust might be just the product to fill a niche in your investment portfolio. If your investment adviser pitches a UIT, make sure that particular fund scratches a niche for you.

Different Type of Fund

A unit investment trust is an investment company in the same boat as mutual funds and ETFs. These companies represent pooled investments, and investors own shares or units as a piece of a portfolio of securities. The Investment Company Act of 1940 defines unit trusts separately from the other types of funds. A unit trust combines some features of mutual funds with features of closed-end funds. UITs are available almost exclusively through investment advisers and commissioned stock brokers.

Defining Features

A unit investment trust holds a fixed portfolio of securities -- either stocks or bonds. The securities in a trust do not change for the life of the UIT, and these trusts have a fixed termination date. The units of a new UIT are sold by brokers through an initial offering and there is no follow-on or secondary market to purchase additional units. Dividends from a UIT, however, can be reinvested to buy more units. Like a mutual fund, the sponsor of a UIT will buy back units an investor wants to sell. The redemption value will be the current net asset value. As a result, you must purchase UIT units when they are initially offered. You may hold onto the units until you decide to sell them back to the sponsor or the trust terminates. At termination, the investments are sold and the proceeds paid in cash to investors.

Types of Unit Trusts

Traditionally, UITs have owned portfolios of tax-free municipal bonds, with all the bonds maturing at about the same time the trust expires. A smaller portion of unit trusts have held taxable bonds. In recent years as of the date of publication, however, unit trusts holding stocks have formed the biggest slice of UIT assets, making up about two-thirds of total trust assets and accounting for up to 90 percent of new UIT sales. A unit trust holds a fixed portfolio, and securities are not actively traded. Trust sponsors have used this feature to sell stock UITs with portfolios of individual stocks selected to meet a specific investment theme.

Investing Considerations

For fixed-income investors, the set termination date of a bond UIT significantly reduces the risk of rising rates and falling bond prices when compared to bond mutual funds. On the stock side, a UIT can provide a single-point investment to use a specific-stock-selection strategy. There is an upfront sales charge to invest in a UIT, but since there is little management of the portfolio, annual expenses are low. When a unit trust terminates, you can get the proceeds in cash or roll over the money to a new UIT at a reduced sales charge.

 

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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