If you’re used to investing in mutual funds – the regular open-ended variety – you’re probably familiar with closed-end funds and exchange-traded funds. But what about mutual funds?
Another variation of the pooling strategy, mutual funds are aimed at investors who want stable income, transparency and liquidity in assets selected by professionals.
“ITUs are good for investors who want to buy and hold securities and earn interest and reinvest dividends over a period of time,” said JeFreda Brown, CEO of Goshen Business Group in Birmingham, Alabama.
While many investors haven’t heard of UITs, there are plenty: 5,188 trusts worth $ 94.13 billion at the end of 2015, according to the Investment Company Institute, the group of fund industry trade. So it’s worth knowing how they differ from close relationships like open-end and open-end mutual funds and exchange traded funds.
Mutual fund. With a regular open-ended mutual fund, your money is pooled with money from other investors and used to buy bonds or stocks that match the fund’s investment strategy.
When you buy fund units, the fund buys more of these holdings and when you sell the fund gets rid of them. You or your advisor deal with the fund company, which is always available to take your investment or redeem your shares. Transactions are carried out at the closing price, or net asset value, calculated by dividing the value of the fund’s assets by the number of shares in circulation.
Closed fund. A CEF is very similar to a mutual fund, except that a fixed number of shares are issued when the fund is created and they are traded like stocks, with prices rising or falling depending on market conditions. Although the number of shares in the fund is fixed, the holdings of the fund can change as the managers buy and sell.
CEFs can be traded at a discount or premium to the net asset value of the fund’s holdings. To exit, you sell to another investor rather than buying back from the fund issuer.
Exchange traded fund. An ETF has a basket of stocks or bonds and trades like a stock, usually following an underlying index like the Standard & Poor’s 500. Unlike a CEF, an ETF has a mechanism to ensure that the market price closely follows the net asset value, minimizing discounts and bonuses.
In most cases, the fund’s positions only change if the underlying index changes its constituents. Otherwise, there is no active management.
Mutual fund. ITUs are similar to closed-end funds and are traded on an exchange or bought and sold through the issuer, except that ITU has a specified life, often one to five years, and its holdings are fixed at departure and do not change. At the end of this period, investors – called unitholders – receive a payment based on their share of the fund’s assets, much like getting the principal back when a bond matures.
Like ETFs, ITUs, once set up, are passively managed – there is no team of analysts looking for hot stocks or bonds – and ITU’s holdings remain the same throughout the life of the fund. Lack of management keeps annual fees low, although some experts warn brokers can charge high sales commissions.
Among the advantages. ITUs, unlike open-end funds, protect investors from unwelcome end-of-year capital gains distributions that can result in tax bills. Since the ITU is not involved in active buying and selling activities, it has not realized any sales gains during the year to be allocated at year end. When you buy an ITU, the gains for the year at that time are already reflected in the unit price, while they may not be reflected in the price paid for an open fund.
Traditionally, ITUs holding bonds – especially tax-free municipal bonds – have been more popular than those holding stocks, but that has changed in recent years with very low bond yields and many investors keen to share in the stock gains.
Typically, investors buy and sell through a broker, although some UITs’ prices are listed on the Nasdaq mutual fund listing service.
“Investors typically buy UITs for income,” says Sterling D. Neblett, founder of Centurion Wealth Management in McLean, Virginia. “Because the securities held by ITUs remain unchanged for a fixed period of time, investors are generally able to determine the income that will be generated.”
Income is usually paid monthly.
Jordan Niefeld, a planner in Aventura, Florida, says ITUs offer an easy way to achieve diversification, and because the portfolio is fixed, the investor knows what they have at all times. And UITs are liquid, since the investor can enter or exit at any time.
ITU holdings are listed in the offering documents. Without active management, the fund cannot adapt to changing market conditions. The smart investor must therefore monitor the risks and returns of the portfolio and know when to exit when conditions deteriorate.
The fixed holding period, while providing predictability, adds another risk, as the unitholder can get their money back at a time when the prospects for reinvestment are low. To manage this risk, the unitholder can monitor market conditions and sell early, but it takes more work and know-how than many fund investors are willing to do.
ITUs therefore offer diversification, liquidity and an unusual amount of transparency and predictability of revenues. But, as a product typically traded through a full-service brokerage, the costs can be high. Make sure you get quality advice in return.
“As a financial advisor, I would never recommend buying UITs,” says Neblett.
“ITUs essentially wrap up an extra layer of high fees for an initial selection of investments that are not even actively managed over the life of the ITU,” he says. “Investors are much better off buying the underlying securities directly at no additional cost. “