What is a unit investment trust? An easy way to build diversification while earning steady income

• A unit investment trust (UIT) is a type of investment fund that offers a fixed portfolio of stocks, bonds, and other assets for a set period of time.
• UIT portfolios are typically fixed and not actively managed or traded.
• UITs are particularly popular as diversification tools for hands-off investors and the retirement community, where stability is prized.

If you've avoided mutual funds because of high management fees or how frequently they can be traded, you might benefit from a closer look at the unit investment trust, or UIT.

Like mutual funds, UITs pool investor funds to purchase a series of assets, which are then bundled and offered up as a single unit - making them great for portfolio diversification.

Unlike mutual funds, UITs are designed to be bought and held until a specific maturity date, with extremely limited trading in the meantime. Because of this, the funds tend to be particularly popular with buy-and-hold investors where stability is more highly valued.

As of December 2020, the Investment Company Institute (ICI) reported that there were 4,310 outstanding UITs, representing $77.85 billion invested, so a booming industry awaits the interested investor.

What is a UIT?

A UIT is one of three basic types of investment companies. The other two types of investment companies are open-end funds and closed-end funds, which we'll cover later.

UITs offer investors a fixed portfolio that can include stocks, bonds, or other securities in the form of redeemable units. They're public investments that are bought and sold directly through the company issuing them, or through a broker working as an intermediary. Investors can redeem UITs after a set period of time passed, known as the maturity date.

How does a UIT work?

The goal of a UIT is that the passively held assets it contains will provide capital appreciation or dividend income throughout the life of the trust. And while that outcome isn't guaranteed, UITs are regulated through the Securities and Exchange Commission (SEC), so concerned investors can breathe easier. Every UIT must register through the commission, which then enforces requirements about everything from where the fund can invest to under what circumstances trades can be made.

The average UIT is typically made up of mostly stocks and bonds, but can also contain assets like mortgages, real estate investment trusts (REITs), master limited partnerships (MLPs), hybrid instruments like preferred shares, and beyond. These assets are often fixed around a broad theme, like American stocks offering historically high dividends, or corporate bonds from companies in a specific sector.

Money managers select assets for inclusion at the creation of the trust, aiming for securities they think will offer the most capital appreciation over time. They also set the maturity date for the fund, which can be anywhere between 15 months and 30 years. After that, the fund remains largely undisturbed until its maturity date.

A prosperous UIT will earn its investors income in two different ways: in the form of quarterly or monthly dividends throughout the life of a fund, and as capital appreciation when the fund matures. Once your UIT expires, you have the option of taking delivery of the underlying assets into your own brokerage account, reupping into a similar or identical trust, or liquidating your holdings, which would give you the current cash value.

UITs vs. mutual funds

Mutual funds and UITs are similar in that they're pooled funds overseen by a professional money manager, and are subject to SEC regulation. Here's how the two assets diverge:

• Mutual funds are actively managed and UITs are not: The ability to buy and sell assets within a mutual fund increases the potential for capital gains - and, of course, losses. Since UITs don't actively trade, fees are lower, and as fixed income investments, their underlying securities do not change except in rare cases like bankruptcy or merger.

• Mutual funds and UITs structure dividends differently: While mutual funds are designed to reinvest your dividends, UIT investors can miss out during market upswings, as the latter doesn't allow for the purchase of additional shares.

• UITs have a maturity date, while mutual funds do not: Much like bonds or CDs, UITs have defined lifespans and set metrics to hit before their expiration. This makes UITs, by their nature, a more long-term investment than mutual funds.
• Mutual funds and UITs offer different ways to invest: If you have the cash to invest in a mutual fund, you can purchase shares on demand, as their quantity is limitless. But since UITs have a set limit or shares released upon its initial public offering (IPO), you have to invest within that window or be subject to the whims of the secondary market.

Each investment type has its own limits. But by and large, the reason you'd see a portfolio organized as a UIT instead of a mutual fund is to minimize both short-term and long-term expenses.

UITs come with much lower expense ratios and also come with favorable tax terms. Because of the way capital gains taxes are structured, it's possible to lose money on a mutual fund and pay taxes on gains you never actually appreciated. For example, if the shares were sold right before you got your hands on them, you could find yourself with a shared tax liability for someone else's capital gains.

But that won't happen with a UIT. Because the securities are bundled when you place the order and not before, the original value - or cost basis, as it's termed - is specific to you and can't burn you down the road.

Who should buy UITs?

UITs have benefits to offer every investor, but they're particularly compelling for those who aren't interested in building a portfolio security by security, or who don't want to pay the high expense ratios on actively managed mutual funds. Plus, the lower buy-ins on UITs make them more accessible for newer investors or those with less capital.

UITs are also quite popular with those at or close to retirement age because they tend to be more stable investment vehicles. While UITs might not have the growth potential of a different asset class, their buy-and-hold strategy is lighter on risk as well. From the very start, you'll know exactly where you're invested, how long that investment will last, and roughly how much income you can expect from your investment, all without having to wait to pore over a prospectus.

If you're looking to join the ranks of UIT investors, these funds can be purchased directly from the issuer, or bought and sold on the stock exchange. Talk to your financial adviser about which UIT might be a match for you and your situation.

The financial takeaway

As an investment, UITs are a different option from mutual funds or closed-end funds that offer a winning combination of low costs, reliability, tax protection, and fairly predictable gains.

There are certain pitfalls, of course, like a lack of flexibility and a potential cap on earnings, since dividends can't be reinvested. But if you're nearing retirement or simply trying to stretch a dollar, UITs can prove to be a plum choice for the (semi) conservative investor looking to diversify their portfolio.

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