"There are few cases," Edgar Allen Poe once wrote, "in which mere popularity should be considered a proper test of merits." That's the sort of sentiment that could be applied to equity unit investment trusts, the decidedly unsexy investment category that closely resembles a closed-end mutual fund and has a set lifespan. While sales of equity UITs have risen over the last few years, they are not likely to get chatted about at cocktail parties and probably won't be associated with the adjective "hot." The irony, however, is that most investors are unaware that the product that is all the rage right now--the exchange-traded fund--is really a second- generation UIT.
The ETF was created in January 1993 when the American Stock Exchange issued the SPDR or Spider, a tradable basket of securities that tracked the 500 companies in the Standard & Poor's Composite Stock Price Index. The Spider was considered a fresh investment concept. The truth is, it wasn't so fresh. The SPDR was assembled as an equity UIT, which meant its holdings were defined and transparent, it was not managed, it had to be purchased through a brokerage account, and any dividends earned were paid to unit holders--not reinvested.
Nevertheless, there were differences between the Spider and a traditional UIT. The Spider did not have a true termination date; it was traded throughout the day on the Amex; and it was given a security symbol, SPY. Thanks, in part, to an aggressive marketing campaign by Amex, SPY took off, and investors poured money into it. Currently, there is more than $65 billion in the Spider, making it the most popular ETF.
The widespread enthusiasm for ETFs, however, is relatively new, with their growth surge occurring over the last two years. Recently, investors have been drawn to ETFs because in a single vehicle they achieve two of today's preferred investment approaches--buy-and-hold and indexing. Equity UITs provide the same benefits, and not surprisingly, they have also experienced a boom.
Historically, UITs were concentrated in the municipal bond market; they were a fairly simple way for investors to access this costly and complicated sector. Now the universe of UITs has been upended. The Investment Company Institute reports that annual assets in equity unit trusts have increased almost seven- fold in the last 15 years, from a mere $4.2 billion in 1990 to $28.6 billion last year. Meanwhile, municipal bonds accounted for 87 percent of the UIT market in 1990, but represented only 24 percent of the industry in 2005. Interest in equity UITs also grew because of the downslide in interest rates during the late 1990s, which, for a while, suppressed the appetite for bonds.
But perhaps the greatest explanation for the expansion in equity UITs was that the offerings became far more creative, mirroring the exotic products typically found on the menus of mutual funds. For instance, in 2001, UBS AG began sponsoring a one-year Dogs of the Dow UIT. That trust, which is still available today, follows the strategy Wall Street guru Michael O'Higgins advocated in his 1991 book, Beating the Dow. O'Higgins proffered that you could beat the Dow Jones Industrial Average in the long run if you created a portfolio of the 10 Dow stocks with the highest yield--the so-called Dogs--and recalibrated the portfolio annually. UBS now rolls out the Dogs UIT every other month. After the 12-month trust ends, investors have the option--as they do with most UITs--to roll their money over into the next Dog series or cash out. Because of their preconceived termination date, UITs are a convenient way to execute the Dogs strategy, and lately these UBS UITs have fared rather well. When the last three Dogs terminated, unit owners saw annual returns of 20.4 percent, 14 percent and 9.2 percent.
For his part, O'Higgins is dismissive of the Dogs unit trust--or any UITs for that matter. He says wealth managers should be the ones assembling portfolios for clients rather than relying on others. "They're for amateurs," says O'Higgins, who runs his own money management firm in Miami. "I've done it a few times with municipal bonds, but that was years ago, and it's not something I'd do now." O'Higgins claims he's grown tired of the stock market and prefers commodities, like the precious metal fund he's created for his clients.
Still, fans of UITs argue that O'Higgins's assumptions are wrong, and that people shouldn't brand these pools of securities as unsophisticated just because they are not actively managed and are created by investment firms. Rich Stewart, product manager for unit trusts at UBS AG, says unit trusts are suited for savvy investors and particularly well suited for wealth managers looking to add diversity to high-net portfolios. For one thing, UITs should entice wealth managers, he argues, because the trusts give clients instant access to a deep bench of market specialists. These specialists design the unit trusts to outperform specific indices or to include the best companies within particular market segments, such as renewable energy and real estate.
"The professional selection that a sponsor like UBS can bring is immense," Stewart says. "We have experts such as market analysts, industry analysts and credit analysts that help build these trusts, and advisors would be hard pressed to replicate that." Sometimes UITs are pure creations of these investment teams. Take Claymore's Dreman Contrarian Value Trust, a three-year equity UIT that is a rare assortment of 95 securities that manages to include everything from foreign holdings to domestic medium and large caps to REITs. It's created by Dreman Management, a company started and overseen by David Dreman, the financial heavy hitter who made a name for himself as the "Contrarian Investor."
Another aspect of unit trusts is that they are transparent. Every security in the trust is disclosed. Financial advisors know exactly what's in them, and it's something they can explain to clients. "You can go to our Web site anytime and see what's there," says Christian Magoon, managing director of product development at Claymore Securities, Inc., which creates UITs. "It allows you to know what you own and what you don't own. You can see that there are no Enrons in the holding, for example. And that's something you can quickly tell your clients if they ask."
Transparency also means that UITs are immune to style drift--the perilous course sometimes taken by fund managers to realign holdings away from a fund's purpose to generate positive returns during market shifts. Any advisor who builds a client's portfolio with a good deal of care is likely to suffer the pains of style drift: If a restless fund manager effectively scrambles, say, a growth fund into a balanced fund, asset allocation--including risk exposure, returns and time horizon--will likely be thrown completely out of whack. The strength of UITs is they offer both the transparency of an ETF and the expertise you get with a mutual fund. In fact, equity unit trusts could be thought of as a happy middle-ground between mutual funds and ETFs. Professional selection means equity UITs are not market weighted in the way ETFs are. And unlike mutual funds, style drift doesn't haunt unit trusts.
For UITs, however, transparency is something of a double-edged sword. Advisors say that because they can peer under a trust's veil, they tend to second-guess the choices that have been made. "Whenever I look at them, I don't see the logic of how they were put together," says Mari Adam, a CFP in Boca Raton, Fla. whose fee-only firm has about $50 million in assets under management. "And because you're committing to this exact roster for a specific period of time, you have to have a lot of confidence in the people who are putting them together."
Another advisor, Brian Breidenbach, an RIA, CFA and CPA in Lexington, Ky., says the reasons to buy UITs are unpersuasive. "I think these things are mostly a marketing gimmick," he observes. "These funds are not actively managed, so why not go and buy the same stocks and avoid the commission fees?" The same could be said of ETFs, of course. Also, while it may sound easy to duplicate a UIT, investors and wealth managers would likely find recreating a UIT complicated, expensive and time-consuming. After all, unit trusts often include a large number of stocks in various amounts.
Nevertheless, wealth managers do cite fees as the main reason they have avoided equity UITs. In recent years, however, most sponsors have substantially reduced sales charges for investors buying unit trusts with fee-based RIAs. "Fee-based accounts are now available," says Claymore's Magoon. "Since we're not paying the advisor, there's a significant cost advantage for investors and for us."
What's more, UIT fees can be smaller than a mutual fund's because you're not paying for the services of an active manager. The costs of buying a UIT include a sales charge, which is embedded in the offering price, and a commission fee. The commission fee is fairly insignificant for high-net-worth buyers because the commission is a nominal one-time charge that is the same whether you're investing $1,000 or $10,000. Commission fees are not applied when UIT investors reinvest dividends to buy more units or when investors roll over into the next trust series after a UIT terminates. Some UITs also charge a small annual fee to cover operating expenses and reimburse the trust sponsor for creating and developing the fund. Overhead for UITs is relatively low because the trusts are not heavily marketed--especially after the sales period has ended.
"Mutual funds have hidden marketing budgets built into their cost structure, and ETFs like the Nasdaq QQQ sell sponsorships, and those sponsors pass on their costs, including advertising budgets, to investors," Magoon notes. "Unit investments don't have marketing and advertising budgets. That also means they haven't been promoted as well as the competition."
Michael Decker, senior vice president of The Bond Market Association (which recently merged with the Securities Industry Association to become SIFMA), points out that all UIT fees are disclosed. Because there's no buying and selling of portfolio securities, equity UIT investors aren't hit with varying transaction costs or taxes. Capital gains taxes are paid only following the dissolution of the trust (assuming the UIT made money). On the other hand, mutual funds usually generate unexpected capital gains taxes, which are, in effect, hidden fees. "One of the things that has always made UITs popular was the idea that you could better manage tax liability," Decker says. "With mutual funds, you get unanticipated capital gains and losses."
Another notable feature of equity unit trusts is that they provide income. Trusts dole out dividends on a regular basis, and they pay out the appropriate share of any capital appreciation earned when the UIT terminates. "UITs are a good way for advisors to structure portfolios to generate income," Decker says.
No matter what the benefits, advisors point out that there are clients who will never have the stomach for a UIT. "For some, UITs work beautifully well," says CFP Jack Harmon, who is based in Atlanta. "But there are others who will see the money valuation when the UIT ends and wonder what the heck happened. Those people are just better off in mutual funds that don't suddenly end."
Mark Francis Cohen (email@example.com), whose work has appeared in the Washington Post and the New York Times, is a Washington, D.C.-based journalist.