What Is a Unit Investment Trust (UIT)?

As an investor, there are various investments and vehicles to add to your portfolio. One of the most common, however, are funds that expose you to many types of assets to diversify and minimize risk. And while options such as mutual funds and index funds often jump to the forefront of our minds, unit investment trusts (UITs) are another worthwhile option.

This article will explain in detail how UITs work, including an overview of how they’re taxed, the cost to invest in them, and the different types. We’ll also break down their positives and negatives.

How Unit Investment Trusts Work

A unit investment trust (UIT) is a fund that invests in a specific portfolio of securities over a fixed period. While their strategies may vary, they often include a diversified array of stocks and bonds curated by experienced finance professionals. The primary objective for the UIT, including planned asset purchases, is available in the fund’s prospectus.

UITs form out of an initial public offering, where investors put their money into the fund to raise sufficient capital to invest in a desired portfolio. Therefore, to invest in a UIT, you must buy redeemable units of ownership in the fund, making you eligible to receive the proceeds it yields when it matures. Since these are redeemable, you could sell them back to the trust at net asset value (NAV), either at a loss or gain.

Classified as an investment company that must uphold a registration with the U.S. Securities and Exchange Commission (SEC), UITs are one of three primary types, also including open-end (mutual funds) and closed-end funds. Unlike mutual funds, however, UITs don’t aim to beat the market with an active trading strategy. Rather, after the managers select the investments within the fund, they remain in place until its holding period ends, effectively using a “buy-and-hold” method.

How They’re Taxed

The taxation of UITs depends on the account in which you’re holding them. For example, if you invest within a tax-deferred retirement account such as a 401(k) or IRA, you’ll owe money to the Internal Revenue Service (IRS) when you begin withdrawing funds. In other cases, however, you’ll need to pay taxes on your returns.

This takes place “in a manner similar to mutual funds,” according to Taylor Kovar, founder and CEO of Kovar Wealth Management in Lufkin, Texas. “Investors in UITs are subject to capital gains taxes when units are sold at a profit or when the trust is terminated. Additionally, any income generated by the UIT, such as dividends or interest, is passed through to investors and taxed accordingly.”

“It’s important for investors to consult with a tax advisor to understand the specific tax implications of investing in UITs,” Kovar stresses.

How Much They Cost

Putting your money in a unit investment trust may come with an assortment of costs you should keep in mind. Here are some common fees associated with UITs:

• Sales charge. You’ll likely need to pay an upfront sales charge (also known as a load). You may also need to pay this on a deferred basis.
• Management fees. You may also encounter costs related to administration, accounting, and sponsorship of the trust by the overseeing organization.
• Advisory fees. Some financial advisors may recommend UITs as part of a portfolio management service. In these cases, you may need to pay advisory fees on top of the other expenses connected to the trust.

Types of UITs

There are two categories unit investment trusts may fall into, each denoted by the securities they largely focus on:

• Fixed-income. These primarily invest in a diverse portfolio of bonds or additional fixed-income assets. According to the Investment Company Institute (ICI), these may distribute income on a more frequent schedule (e.g., per month).
• Equity. These focus on a collection of common or preferred stock and generate income based on capital gains and dividends. Because equities are generally more volatile and rely on the performance of a given company, these funds may carry a higher level of risk than their bond-focused counterparts.

Though the above are the notable umbrellas that any UIT may fit into, keep in mind that each one will have a unique strategy. This may affect the level of risk at play, as well as the overall investment approach. Kovar notes, “Within these categories, UITs can focus on various sectors, geographies, or investment themes, such as technology stocks or municipal bonds.” For instance, you may land on a fund that focuses primarily on international equities, while you could see another one that prioritizes environmental, social, and governance (ESG) investing.

Pros and Cons

UITs can be an effective investment for diversification, as well as their simple “set-and-forget” strategy that lessens the chance of falling prey to losses due to portfolio over-optimization. However, other factors, such as their illiquidity, may be enough to discourage investors from trying their hand with them.

Below are their advantages and disadvantages:

Pros

• Allows you to invest in a fund with a particular collection of securities, which creates a heightened level of transparency.
• Operates over a specified time horizon.
• Follows a hands-off buy-and-hold philosophy. Per Kovar, this “prevents fund managers from making potentially detrimental changes to the investment strategy.”
• May provide regular income via dividends or bonds.

Cons

• Largely illiquid, as redeeming units could lead to losses.
• Because the strategy doesn’t change, the trust may not adapt to unforeseen downturns.
• Requires an upfront sales charge, which may be costly.

Who Should Invest in Them

Mutual funds and exchange-traded funds (ETFs) often take the limelight when we think of ways to diversify our assets. However, unit investment trusts are also effective vehicles that can accomplish this purpose, while providing a clear-cut investment objective.

So, who should consider UITs? Kovar highlights that they “can be a good fit for investors seeking a diversified portfolio with a fixed investment horizon.” He adds that “[t]hey are particularly suitable for those looking for a passive investment strategy, as UITs are professionally selected portfolios of securities that are not actively managed.”

Before investing in them, though, you should think about whether you’re comfortable with their inflexibility. In many cases, they take a long commitment and may not produce the results intended by the managers of the trust.

Therefore, it’s important to thoroughly read any materials about a UIT before investing and be sure you understand how they work. For this reason, it’s a good choice to consult a resource, such as a financial advisor, who could clear up any concerns you have. They could also let you know if one of these funds would fit into your long- or short-term plans.

Frequently Asked Questions

Are UITs liquid?

Because they operate over a fixed term with a specified termination date, unit investment trusts are largely illiquid. They also don’t incorporate active management techniques, meaning that the assets within them generally stay put after the initial investment period for the life span of the fund. Since the ownership units are redeemable, you could sell them back to the trust at net asset value (NAV).

This can be a disadvantage, however, per Kovar. “[O]nce invested, your capital is typically tied up until the trust’s termination,” he says. “Additionally, the fixed portfolio means that UITs cannot adapt to changing market conditions, which could be a disadvantage in volatile markets.”

Are UITs risky?

All investments carry risk with them, and UITs are no exception. There’s always a possibility of the market not acting as intended and causing the investments within the trust to underperform, leading to losses. The overall risk for each fund may vary depending on a range of factors, including the team that selects the securities within, the investment strategy in play, and the length of the term.

How can you learn more about a particular UIT?

The best way to learn more about any specific unit investment trust is by reading its prospectus, which is a document that explains important information such as the investment philosophies and strategies you can expect, managers of the fund, and other critical financial details. It’s also a smart idea to speak with a financial advisor. They’ll be able to help you understand what you need to know before investing in one of these funds.