A Unit Investment Trust (UIT) is a type of investment company that offers a fixed portfolio of securities, typically bonds or stocks, for a specified period. Unlike mutual funds or closed-end funds, UITs provide investors with potential dividend income and predictable returns, making them a reliable, low-maintenance option.
Investing is one of the most vital factors in a successful financial plan. It allows your savings, which you would otherwise keep in a savings account, to multiply and provide hefty returns. However, when it comes to investing, the process seems complex as investors have to identify and analyse stocks extensively based on technical and fundamental factors. This may discourage some investors who are not well-versed in the analysis process.
Although numerous investment instruments exist for such investors, such as mutual fund schemes, they can also look toward alternative investments, such as UITs. This blog will help you understand What is a UIT and how it can help you diversify and earn good returns.
What is a Unit Investment Trust (UIT)?
A Unit Investment Trust (UIT) is a type of investment company that offers investors a fixed collection of assets, like stocks or bonds, for a specific period. Unlike mutual funds or closed-end funds, the portfolio in a UIT remains unchanged once it’s created. This means the UIT doesn’t actively buy or sell assets during its lifespan.
UITs are typically designed to provide investors with either growth (capital appreciation) or steady income through dividends. Once the trust reaches its end date, investors receive their share of the proceeds based on the value of the assets in the trust.
Similarly, UITs buy numerous investment instruments and make them available to investors as a fixed portfolio. They work similarly to a mutual fund scheme where investors can invest a specific amount and get proportional ownership in various securities included in the fixed portfolio.
Understanding unit investment trusts with an example
A unit investment trust is a fixed portfolio offering where investors can invest and earn through dividend income and capital appreciation of all the included securities. A UIT works similarly to open-ended and close-ended mutual funds as they include a basket of investments rather than investing the whole amount in a single security. As an investment company, UIT buys various securities, such as stocks, bonds, mutual funds, ETFs, etc., and creates a defined portfolio by adding all the securities bought in a predefined proportion. When investors invest a specific amount, the amount gets invested in all the included securities as per the pre-defined proportion.
However, unlike mutual funds, UITs have a set expiration date based on the investments held in the fixed portfolio. When the portfolio expires, the investors receive a portion of UIT’s net assets based on the amount they have invested. Furthermore, as the portfolio is fixed, it isn’t actively managed and remains the same throughout its tenure.
Here is an example.
- Initial investment: Rs. 1,020
- Quarterly dividends received over 10 years: Rs. 50 x 4 x 10 = Rs. 2,000
- Final distribution: Rs. 1,500
- Total returns: Rs. 3,500 (Rs. 2,000 + Rs. 1,500)-Rs. 1,020 = Rs. 2,480
In this example, the investor benefits from the stable income provided by the high-dividend stocks and the potential capital appreciation of the portfolio over a 10-year period.
Types of unit investment trusts
Here are the types of unit investment trusts:
1. Income funds
Income funds create a fixed portfolio of securities that aims to deliver regular income through dividend payouts rather than focussing on capital appreciation.
2. Strategy funds
Strategy funds aim to beat market benchmarks, such as Nifty, Sensex, etc., or the whole market in general. They rely on extensive fundamental analysis to identify investments that can provide better returns than benchmarks or the whole market.
3. Sector-specific funds
Sector-specific funds identify and add securities in the portfolio that are specific to a sector. Although risky, they may generate good returns if the sector performs well.
4. Diversification funds
Diversification funds focus more on diversifying by including a host of securities with the aim of lowering the overall risk.
5. Tax-focused funds
Tax-focused funds aim to reduce individuals' tax liability by investing in tax-efficient securities. Their main focus is tax-saving and not providing hefty returns.
How does a unit investment trust work?
A unit investment trust works by buying a host of securities, such as equities, bonds, mutual funds, etc., and holding them for a specific time. Investors can invest a specific amount in a UIT, which gets invested in all the securities added to the portfolio as per the predefined investment proportion. UITs are not actively managed, and the investments remain unchanged throughout the tenure. Because of this, UIT investors receive steady and predictable returns suitable for their risk appetite and investment goals.
When investors invest initially, they must pay according to the UIT units' net asset value (NAV) plus applicable sales costs. Unit holders get regular returns from the UIT in the form of interest or dividend income. The UIT expires after the trust’s expiry date, and the remaining securities are liquidated, with the proceeds going to the investors according to the number of their units.
Advantages of UIT
Now that you know what UITs are, let us look at their advantages. Here are the pros of UITs:
- A unit investment trust provides investors with effective diversification as they can invest in a wide range of securities. Diversification minimises the risk level for the investors as the risk gets spread across numerous investments.
- UITs provide the utmost transparency to investors. They are required to disclose their fixed portfolios regularly so investors can see the amount and proportions they have invested. Another advantage is the absence of active management, which reduces the overall cost of UITs compared to other actively managed funds.
- Unit investment trusts have a low minimum investment requirement, which makes them affordable and accessible for beginner investors. Since the portfolio is fixed, investors know beforehand the profit potential and the income they stand to earn.
Disadvantages of UIT
Now that you know what UITs are, let us look at their disadvantages. Here are the cons of UITs:
- Investors have little to no control over their investments as UITs are not actively managed, and the portfolio remains unchanged throughout the tenure. Hence, investors stand to make losses if investments turn negative as there is no adjustment or strategy change, even if the investments are falling in price.
- UITs provide diversification but may fail to provide high returns to investors as the investment strategy is focused more on providing low-risk, steady returns. Also, the diversification is limited compared to other diversified investments.
- Unit investment trusts invest for the long term, which makes them inappropriate for investors looking to book short-term profits. Furthermore, it is difficult to invest in UITs as they are not traded on stock exchanges like mutual funds, which also lowers the liquidity.
What is the primary benefit of a unit investment trust?
The primary benefit of investing in unit investment trusts is the predictable nature of the income and interest. Since these trusts are not actively managed and remain unchanged throughout the tenure, they provide stability to investors as they know how much they are going to earn and how much tax they will be liable to pay.
Additionally, individuals invest in UITs because they can pay regular income from dividends or interest, providing a steady income source without much risk. The low turnover in UITs also contributes to tax efficiency, as investors end up realising fewer capital gains compared to actively managed funds.
How unit investment trusts are sold?
One important factor in understanding what is UIT investment is to learn about how UITs are sold. UITs are created as a fixed portfolio, including numerous securities in predefined proportions. Once created, a single portfolio is sold as a unit to the investors. When they invest, the money gets distributed and invested in all the securities as per the weightage of every included security.
Similar to mutual funds, units are also sold to investors based on net asset value (NAV). Investors can buy these units through a financial advisor or a brokerage firm.
What Is the main risk of a unit investment trust?
The main risk of UITs is their lack of flexibility in the fixed portfolio. Once the portfolio of securities is set, it generally remains unchanged for the duration of the trust, which can range from a few months to several years. This fixed nature means that UITs cannot adjust investments in case investments fall in their prices or the market turns negative. Additionally, since the trust is not actively managed, there is no opportunity to replace underperforming securities, which can lead to potential losses.
UITs and Taxation
When investing in Unit Investment Trusts (UITs), it’s important to understand the tax implications. Any interest, dividends, or capital gains earned from the assets in the trust are typically passed on to the investors. These earnings are taxed as regular income, meaning you may have to pay taxes on them in the year they are received.
In addition to income taxes, you may also be subject to capital gains tax if you sell your UIT units for more than the purchase price. The tax rate will depend on how long you’ve held the units – short-term gains (held for less than a year) are taxed at a higher rate than long-term gains.
Finally, UITs do not actively trade their assets, so they tend to generate fewer capital gains compared to mutual funds. This can potentially result in lower tax liabilities over the life of the investment.
UIT costs
Investing in Unit Investment Trusts (UITs) comes with certain costs that investors should be aware of. One common expense is the initial sales charge, which is a fee you pay when you first purchase units in the trust. This fee can vary depending on the type of UIT and the investment company offering it.
In addition to the sales charge, UITs also have ongoing management fees, known as the creation and development (C&D) fee. Although UITs are passively managed and do not frequently trade assets, these fees help cover administrative costs and the overall maintenance of the trust.
Finally, some UITs may have early redemption fees if you sell your units before the trust’s end date. These costs can impact your returns, so it’s important to understand all the fees associated with a UIT before investing, ensuring that they align with your financial goals.
Unit investment trust vs Mutual funds
Unit investment trusts seem similar to mutual funds but differ in certain aspects. These are:
End dates
Unit investment trusts have end dates. This means that after a specific time, they expire, and investors receive their principal amount back. On the other hand, mutual funds are open-ended funds, where the portfolio manager can buy and sell securities at any time for adjustment or redemption.
Number of shares
Unit investment trusts issue a fixed number of shares during their initial offering period, and no additional units are created afterwards. Investors can buy or sell these units in the secondary market, but the total number of units remains constant until the trust expires. On the other hand, mutual funds continuously issue and redeem shares based on investor orders, which continuously changes the number of shares in the portfolio.
Level of activity
The activity level in UITs is not aggressive as the securities are bought upfront and held for the duration of the trust. However, mutual funds aim to track or outperform the underlying benchmark, and the portfolio manager constantly buys or sells securities to match the investment strategy.
Taxations of unit investment trusts
Unit investment trusts are pass-through investments, meaning the investor’s tax liability is shared. Hence, income, losses, and gains are passed to the investors, who are responsible for filing taxes as per their applicable tax slabs.
The tax treatment for UITs differs based on the type of securities held by the investors in a specific UIT portfolio. For example, if a UIT has paid a dividend, the investors are liable to pay tax on the dividend income. On the other hand, if the UIT is tax-saving, the tax treatment will be different per the provisions of the Income Tax Act of 1961.
UIT costs
Similar to mutual funds, Unit Investment Trusts also have costs such as load and sales charges. These charges are generally based on a percentage of the total amount invested by the investor, ranging from 1-5%.
UITs also charge an annual management fee as a percentage of the total assets held in the UIT. It covers the cost incurred by the UIT in managing the portfolio. However, this cost is lower as UITs are not actively managed.
Another charge is the trustee fee, which covers the costs of various trustees who oversee the UIT. These costs are a percentage of the trust assets or a fixed amount.
Key Takeaways
- Unit Investment Trusts (UITs) offer a fixed portfolio of assets, such as stocks or bonds, that remains unchanged throughout the trust's life. This passive approach means that once the UIT is established, its investment mix doesn’t alter, unlike mutual funds or actively managed funds.
- UITs operate for a predetermined period, typically ranging from one to five years. At the end of this period, the trust terminates, and investors receive a payout based on the current value of their units.
- UITs involve several costs, including an initial sales charge and ongoing management fees, often referred to as creation and development (C&D) fees. These costs can impact overall returns, so it’s crucial to be aware of them before investing.
- Income generated from UITs, such as interest and dividends, is taxable in the year it’s received. Additionally, capital gains from selling UIT units are subject to tax based on the holding period, with short-term gains taxed at a higher rate.
- UITs provide a diversified investment in a single purchase, offering exposure to a range of securities within the fixed portfolio. This diversification can help reduce risk compared to investing in individual securities alone.
Conclusion
Unit investment trusts are US-based investment companies that sell UITs as alternate investment instruments. They buy securities, add them to a fixed portfolio, and sell them as units to investors. Investors can invest in UITs to earn regular income and interest without taking on much risk. They are somewhat similar to mutual funds but differ in certain factors. Now that you know what is a UIT, you can consider adding them to your portfolio along with other instruments, such as mutual fund schemes.
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