Are UITs Better Than ETFs?

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The term “ETF” is used by many investors to refer to a wide range of financial structures that are not technically exchange traded funds under the 1940 law. Most of the most popular ETFs included in our ETF filter Free are technically Unit Investment Trusts (UIT), a type of security that works much the same way as an ETF but has some structural nuances that impact the risk / reward profile.

[Download How to Pick The Right ETF Every Time].

Dividends

One main difference between a simple ETF and an exchange traded ITU, like the S&P 500 SPDR (SPY, A) – is the way dividends are managed.

When an ITU receives a dividend from a constituent company, the fund managers will keep it in cash until the end of the quarter. At the end of the quarter, the dividends received are paid to investors holding units of the fund. ETFs that are not configured as ITU, such as the iShares S&P 500 Index ETF (IVV, A-) —Have the ability to reinvest dividends immediately. This can provide favorable returns to investors during bull markets, as reinvested dividends capitalize on rising stock prices.

However, when the market goes down, the ITUs have the upper hand. By leaving money received from dividends on the sidelines, ITUs do not reinvest that money in declining stocks, which could lead to capital erosion. [see our Monthly Dividend ETFdb Portfolio].

Tracking error

ITU fund managers should track the Underlying Index at all times. For example, the S&P 500 SPDR should be invested in the 500 stocks that make up the S&P 500 index to ensure that the ITU accurately mimics the price movements of the actual index. An actively managed ETF may invest in several products with the aim of recreating the performance of the index or the underlying asset. This type of management can lead to tracking errors – sometimes the ETF can outperform or underperform the underlying asset.

The trading style of the trader or investor will determine which model (UIT or ETF) he should choose to trade. With an ITU, there probably won’t be any surprises apart from what happens to the index. ETFs that are more actively managed may have surprises unrelated to market movements. An example of this occurs when the investments chosen to recreate the underlying asset do not accurately reflect the changes in the price of the underlying asset. [see 5 Important ETF Lessons In Pictures].

Over a long period of time, slight deviations in performance from the underlying asset can be considered of no consequence for the average investor. On the other hand, the large spreads make it difficult to determine what you are actually buying. Therefore, before buying an ETF, take note of the historical performance of the ETF against the benchmark or the asset it is supposed to represent. A little homework ahead of time can avoid a surprise down the road.

Active traders and options traders generally gravitate towards UIT products. The S&P 500 SPDR, for example, has always been the largest ETF / UIT product. These types of traders seek transparency and price action, which is tied to the index on which they have built their strategies. If an ETF does not fall (or fall too much) when the underlying index falls, it is very difficult to develop an active or options trading strategy for such an instrument. ITUs usually don’t have this problem [See 101 ETF Lessons Every Financial Advisor Should Learn].

Loan sharing

Stock lending is a practice where stocks held in an ETF are loaned to other financial companies in exchange for interest charges. ITUs never lend shares. The S&P 500 SPDR, an ITU, therefore does not lend any shares, but the iShares S&P 500 Index ETF does. [see Cheapskate ETFdb Portfolio].

The percentage of profits from the loan of shares paid to the fund is specified in the investment prospectus; the iShares S&P 500 ETF index reinvests 65%; the Vangard S&P 500 ETF (VOO, A) reinvests 100% of the profits from the equity loan in the fund.

Fees and expenses erode earnings over time, which means most ETFs and UITs will underperform their underlying index. Reinvested profits from equity loans help reduce the performance gap between the ETF and the index. In some years, it is possible for an ETF to follow an index closer than an UIT, simply because the profits generated by the stock lending help offset the costs.

SPY vs IVV

SPY and IVV recorded very similar performances from 2008 to the end of 2011 and the table below shows the performances of each fund over four years. Returns include income from dividends and interest payments (applicable to IVV) and capital gains or losses; management fees and expenses have also been deducted.

Teleprinter 2008 2009 2010 2011
TO SPY -36.81% + 26.37% + 15.06% +1.89%
IVV -36.93% + 26.42% + 15.09% +1.86%
S&P 500 Index -37.00% +26.46 + 15.06% + 2.11%

Although there are slight differences in performance from year to year between SPY, IVV and the underlying S&P 500, the risk profiles of the investments are quite similar.

The bottom line

Despite their differences, the S&P 500 SPDR, an ITU, and the iShares S&P 500 ETF performed similarly and share almost the same risk profile. This may not always be the case. Each investment structure has its advantages and disadvantages, which are often highlighted during varying market conditions. An ITU will be somewhat amortized in the event of a market downturn because dividends are not reinvested. Unfortunately, ITUs do not receive any income from stock lending. Managed ETFs have the ability to track errors, dividends are reinvested, and income from stock lending can offset management fees and expenses. Read the investment prospectus carefully and view the past performance of the ITU / ETF against the underlying index to make sure you know what you are buying.

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