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Beware of Pricey Unit Investment Trusts (UITs)

September 2007

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If you have an account with a full service broker, chances are good that someone has tried to sell you a Unit Investment Trust or UIT. They can sound very enticing—selected baskets of stocks or bonds, typically packaged with an interesting strategy, such as investment in the “Dogs of the Dow” or “Alternative Energy” stocks. But buyer beware: these unit trusts are often a very poor substitute for ordinary mutual funds or individual stocks.

A "unit investment trust," commonly referred to as a “UIT,” or “Unit Trust” is one of three basic types of investment companies. The other two types are mutual funds and closed-end funds. UITs or Unit Trust portfolios are professionally selected by a trust sponsor and are designed to follow a stated investment objective, for example, investing in alternative energy companies or the Dow stocks with the highest yield. Van Kampen, First Trust and Claymore are among the most popular sponsors of short-term stock unit investment trusts and they, and other sponsors, sell their UITs mostly through “full service” (non-discount) brokers and high-end money managers.

UITs hold a fixed basket of stocks and not actively managed, so ongoing management fees are often quite low. Except in limited circumstances, unit trust portfolios will hold and continue to hold shares of the same securities whatever the market does. The oddest feature of UITs is that they dissolve on a mandatory termination date ranging from one to thirty years from the date UIT is created.

These days, most brokers are pushing so-called short-term strategy trusts, which typically dissolve after one to two years. Clients are urged to “reinvest” automatically, rolling their units over into another similar newly created unit trust once the old one dissolves.

The big catch that usually makes these short term UITs downright lousy investments is hefty transaction fees, incurred both when the unit is first purchased and again when the unit dissolves. With each trust purchase and dissolution, investors are hit with initial sales charges, deferred sales charges, creation and development fees and organization cost fees. And in a taxable brokerage account, you may owe capital gains taxes each time a UIT matures. Nor are high taxes and transaction fees the only problem with UITs.

Unit trusts can be hard to monitor

Some plan sponsors list the net asset value of outstanding units on their web sites, but as with mutual funds, the NAV is given only after the markets close. If you stay with your high-priced broker, you’ll typically get a fairly accurate date, but if you want to monitor your account independently or if you decide to move your money elsewhere, you could run into problems. Most portfolio monitoring software, for example, that available from Quicken, Morningstar or the Wall Street Journal online, balks at UITs, so values and asset type have to be hand entered. There are thousands of short-term UITs and they are generally not reviewed by mutual fund research services like Lipper, Value Line and Morningstar. It is extraordinarily difficult to find comparative information on many UITs, so investors are well advised to take their time, really, really read the prospectus, drive their brokers crazy with questions, and do deep internet searches to comparison shop before they buy.

If something goes wrong, you may be stuck.

A UIT typically will make a one-time “public offering” of only a specific, fixed number of units. Many UIT sponsors, however, will maintain a secondary market that allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors. However, unit trusts bought back by the sponsor before the termination date are typically discounted—meaning that the investor receives less than the net asset value of units. This is especially problematic when the units are invested in volatile and risky sectors, such as emerging markets stocks, where prudence calls for regular rebalancing and profit-taking. Further, a UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust, so if something goes terribly wrong with the strategy in mid-stream, the trust will not change course and the investor will be stuck.

Here’s more on how the costs add up.

For one simple example, let’s take the Dow Target 10 Portfolio March 2007 series from sponsor First Trust. This interesting trust follows the “Dogs of the Dow” strategy, investing in the 10 highest yield stocks in the Dow Jones Industrial Index in any given year. (Here’s the link to the prospectus.)

Nice idea, and sometimes the “dogs strategy” works. The Dow 10 unit trust also looks okay in terms of ongoing costs (a mere 0.184%), but that apparent advantage disappears when one digs a little deeper to find the fee table on page 6 of the prospectus. Here, a little light reading makes it clear that the investor faces at the outset a 1.0% initial sales charge, a 0.50% creation and development fee, a 0.29% estimated organization cost. Next the hapless investor faces a 1.45% deferred sales charge levied over three months after the unit is purchased. The March 2007 series is scheduled to dissolve on May 15, 2008, 14 months after its creation, at which point on a $10,000 investment, one would have forked over $342 in fees and expenses. In contrast, executing the same Dow 10 strategy yourself through a discount broker would cost you at most about $140–$200 in commissions.

But how about more complex portfolios or more “sophisticated” strategies? Are the fees justified for specialized short-term strategic unit trusts with larger numbers of holdings? Again, generally not. We used the Securities and Exchange Commission (SEC) mutual fund cost calculator to compare the cost of buying the short term Claymore BRIC (Brazil, Russia, India and China) emerging markets unit trust with buying an exchange traded fund (iShares MSCI Emerging Markets Index Fund ETF; ticker symbol EEM) that can be purchased through any broker and that invests in companies from all four of these countries, among others. The cost over the two-year holding period for the Claymore unit trust was three times what you would pay for the iShares ETF bought and sold through a discount broker.

Some UITs are good investments.

Many exchange traded funds (including iShares) are structured as long term UITs, minus (for individual investors) most of the charges we’ve just discussed. For the long-term individual investor in these kinds of UITs, the only fee that one has to worry about generally is the annual expense ratio or management fee and the brokerage commission (which can be as low as $5 per trade, if the purchase is made through a discount broker).

Individual investors in short term UITs who are able to invest very large sums of money may also get breaks on fees either at the time of initial investment and/or when the trusts are rolled over. But be sure to ask your broker lots of detailed questions about what fees are levied and when; be prepared to crunch the numbers for yourself and find out what competing products are out there that might give you the same type of investment for less money; and don’t be afraid to haggle with your broker for a better deal.

One can sometimes purchase units at a discount to their net asset value after the initial offering. That can provide enough of a cost break to make the investment more attractive.

Some of the best UITs invest in bonds rather than stocks.

Bond UITs often have termination dates of 20–30 years after the initial offering. The trustee or sponsor simply collects the interest income and cash flow from the repayment of the bonds, and distributes the funds to the unit holders until all bonds mature or are called. Because the investments are not directed, annual fees charged to maintain the trust are sometimes lower than fees charged for managed funds. Long-term bond UITs may provide investors with a diversified portfolio of bonds that offer different maturity dates and an average holding period that complements their financial need. Bond UIT participants purchase shares with the expectation of earning a steady monthly income and then receiving most of their principal back at expiration. Investors theoretically get the benefit of holding bonds until maturation without the volatility and risks inherent in short-term trading. And, unlike in managed funds, UIT shareholders know exactly what they are buying and holding—no need to worry late at night that some bond fund manager has taken it into his head to load up on sub-prime mortgage-backed obligations. What you owned in 1993 is what you own in 2007. Purchased in the secondary market at a discount, bond UITs can be especially attractive—but do your homework to understand if the discount reflects a real problem with the holdings.

Want an objective second opinion?

Responsible Investing provides cost-effective research services that give you the information you need to make an informed decision. Contact us for more information or to schedule a free initial consultation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.