- How Does a Unit Investment Trust Work?
- What Is the Difference Between a Unit Investment Trust Fund and a Mutual Fund?
- How Are Unit Investment Trusts Taxed?
- Are Unit Investment Trusts a Good Investment?
A unit investment trust buys a portfolio of securities in line with the investment objectives in its prospectus. It then sells units to investors via an initial public offering. Here’s what else you need to know.
Unitholders partake in the gains and losses of the investments in the trust based on the rise and fall of the UIT’s net asset value. For example, if the value of the investments in a UIT rise in value from $100 to $101, each unitholder will see a rise in their investment value of 1% for that day.
During the life of the UIT, the underlying portfolio generally remains fixed and doesn’t change. This makes UITs a so-called “passive” investment, as opposed to “active” investments in which managers buy and sell securities on a regular basis.
Most, but not all, UITs have a stated maturity date. Upon maturity, the UIT will liquidate, and sales proceeds will be distributed to remaining unitholders. Before the maturity date, investors can liquidate their units at the current net asset value.
In some cases, UIT holders may elect to receive an “in-kind” distribution. With an in-kind distribution, a unitholder receives a distribution of securities, rather than cash. For example, imagine a UIT that owns 100 shares of stock in 10 different companies, and that you own 1% of the entire portfolio.
With an in-kind distribution, instead of cash, you would receive one share of actual stock in each of the underlying securities. However, in-kind distributions are often only available to large, institutional holders with sizable positions. Specific distribution rules may vary by issuer.
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A UIT is a clearly defined and unmanaged portfolio of securities with a specified life. Unit investment trusts are constructed out of stocks and bonds by a third party — called a sponsor — and the set portfolios are then sold through brokers to investors.
A mutual fund, on the other hand, is generally an actively managed portfolio with no specified maturity date. As with a unit investment trust, investors can buy or sell shares of a mutual fund every day, transacting at the then-current net asset value.
Unlike UITs, mutual funds don’t generally have maturity dates. As open-ended investment companies, they continually issue and redeem shares on an as-needed basis. Mutual funds don’t offer in-kind distributions either.
Unit investment trusts are taxed, just like any other capital investment. For any distributions of income, unitholders pay regular income tax. For capital gains distributions, the capital gains tax rate is used. If a unitholder sells a UIT before maturity, the proceeds will be treated as a gain or loss based on the original purchase price.
For example, if you pay $10 per unit and sell out at $12 per unit, you’ll have a taxable capital gain of $2 per unit, assuming you haven’t reinvested any distributions. If you’ve held the UIT for one year or longer, you’ll benefit from long-term capital gains treatment. If you sell your units less than one year after purchase, the proceeds will be taxed as a short-term gain at your ordinary income tax rate.
Unit investment trusts are neither inherently good nor bad investments. The question is whether or not UITs are appropriate investments based on your own personal financial situation. To be a good investment, a UIT must meet your personal investment objectives and risk tolerance. You must also be comfortable with the UIT structure, which is generally static and finite, with an unchanging portfolio and a set maturity date.
For example, if you prefer to do your own research and pick your own stocks, a UIT would not be the right investment for you. Similarly, if you prefer hiring a professional money manager to actively buy and sell stocks on your behalf, a mutual fund might be more appropriate for you. Only if you are satisfied with a set portfolio that will remain unmanaged and ultimately self-liquidate should you consider the UIT structure. Also, be sure to factor in how fees may eat into the total return of your investment.
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