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How Do Unit Trusts Work?

Original post by Dana Griffin of Demand Media

Unit investment trusts offer unit-holders a stable way to invest while continuing to receive positive profits.

There are three types of investment companies: mutual funds, closed-end funds and unit investment trusts. A unit investment trust (UIT) is a professionally monitored investment portfolio that trades a fixed pool of profitable securities, such as stocks and bonds. Investors who want a stake in the trust buy units and receive dividends on those shares.

Formation

A trust indenture is necessary in order to form a UIT. The fund's sponsor creates the indenture document and names the trustee and evaluator. It is the sponsor's responsibility to designate securities for the fund. Administrative duties fall to the trustee who keeps securities, unit-holder records and carries out accounting and tax reporting. At inception, unit investment trusts establish a termination date. On this date, the trust sells its remaining securities and divides the profits among investors. It is important to note that UITs do not have a board of directors, corporate officers or investment advisers.

Securities

According to Investment Company Institute, "securities in a UIT are professionally selected to meet a stated investment objective, such as growth, income, or capital appreciation." UITs sell a fixed number of units at one-time public offering. Securities in a UIT do not trade actively, rather, UITs use a strategy known as buy-and-hold. The UIT purchases a certain amount of securities and holds them until its termination date. Holdings rarely change throughout the life of the trust so unit holders know exactly what they're investing in, and the trust lists all securities in its prospectus. Unit trusts normally sell redeemable units - this obligates the trust to re-purchase investor's units at their net asset value at the investors request. By purchasing an assortment of stocks and bonds, the UIT reduces potential risk for its investors.

Bond Unit Investment Trusts

One type of unit investment trust is a bond trust. Sponsors can develop a corporate, international, national or state municipal bond trust. A corporation's bonds, held in a corporate bond UIT, aim to receive high amounts of income with low risk. To reduce risk, corporate bond UITs either purchase private insurance to secure prompt payments of interest and principle or solely hold quality, investment-grade bonds. National and state municipal bond UITs purchase securities used to finance road maintenance, hospitals, schools and other public works. National municipal bond UITs purchase securities on a national level, while state municipal bond UITs only hold securities from one state. International bond UITs offer entry to foreign fixed-income markets, holding debt issues from foreign companies and governments. Owing to exchange rates, these trusts may incur more cost and profit fluctuations, but the potential returns tend to be higher than average.

More UITs

In addition to bond UITs, sponsors can form an equity UIT. This type of portfolio contains pre-selected domestic and international stocks. Equity UITs tend to focus on specific markets like healthcare or energy. Mortgage-backed securities are another type of UIT available to investors. These trusts hold mortgages backed by government financed concerns and have high income potential. U.S. Government securities UITs hold securities like U.S. Treasury bonds or notes. Investors consider government securities to be safe, low risk investments.

                   

References

About the Author

Dana Griffin has written for a number of guides, trade and travel periodicals since 1999. She has also been published in "The Branson Insider" newspaper. Griffin is a CPR/first-aid instructor trainer for the American Red Cross, owns a business and continues to write for publications. She received a Bachelor of Arts in English composition from Vanguard University.

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