Some of Wall Street’s hottest investments can’t be found on a stock exchange. And they’re not grabbing headlines in personal-finance magazines. But you’re probably hearing a lot about them from your broker.
Unit investment trusts, unmanaged investment portfolios with preset maturities, are being promoted by Merrill Lynch & Co., Travelers Group’s Smith Barney Inc., Prudential Securities Inc. and a growing number of other brokerage firms for investors seeking performance, diversification and peace of mind.
With investment minimums as low as $250, for individual retirement accounts, they are being sold as a way for the little guy to buy a stake in a collection of securities that only a millionaire could afford to own outright.
Investors are snapping them up. In the first eight months of the year, they steered $24.6 billion into unit investment trusts, compared with $13.4 billion in the year-earlier period. Assets in the trusts soared 88 percent in 1996 over 1995.
“Our success is the best-kept secret of Wall Street,” boasts Ken Swankie, manager of the unit investment trust department at Prudential Securities, a subsidiary of Prudential Insurance Co. of America.
But as far as some critics are concerned, many people would be better off with mutual funds or individual stocks. The popularity of unit investment trusts is “a triumph of aggressive marketing to a captive audience,” scoffs John Markese, president of the American Association of Individual Investors. “They are fixed portfolios that add costs but not necessarily performance.”
Unit investment trusts were designed in the early 1970s to sell bonds, then adapted in the early 1990s as a stock-investment vehicle, competing with index funds.
The stock-market trusts are easy to understand–and sell. A brokerage firm buys large blocks of stock, typically in as few as five or as many as 25 companies. It then puts the shares into a trust, and sells units in that trust to clients.
During the trust’s lifespan–from a year to five years–the portfolio usually remains untouched, though dividends may be paid out. The trusts aren’t publicly traded, but investors can ask the brokerage firm to buy back the holdings at a price close to net asset value.
The investments appeal to people puzzled by the stock market’s gyrations and the uneven performance of many mutual funds. And the returns on many unit investment trusts have been large enough to keep them from worrying about potential drawbacks.
“You can’t sneeze at annualized returns of about 30 percent,” says Alan Hansen, a Portland, Ore., investor. “And I don’t have to figure out what kind of investment style my mutual-fund manager has and what he’s up to this month.”
The most popular unit investment trusts are the “Dow Dogs” products, based on the theory that investors will reap rewards by buying the 10 stocks in the Dow Jones industrial average with the highest dividend yields. “Investors are comfortable with household names like this,” says Swankie.
But as investor interest has exploded, so has the list of choices. Want to own a portfolio of fledgling biotechnology stocks? Talk to Principal Financial Securities Inc. in Dallas, which believes the trusts are a less risky way than individual stocks to bet on this sector.
On the drawing board at Smith Barney: a unit investment trust owning stocks the firm expects to benefit from the aging of the Baby Boom generation. Meanwhile, Charles Schwab & Co., which has sold other firms’ unit trusts, is in the midst of launching its own Dow Dogs product, undercutting fees at most other brokers.
Most brokerage firms charge a 1 percent load for the unit investment trusts they sell, and deduct another 1.75 percent annually from the net asset value, in 10 monthly installments. Investors who roll over their holdings in subsequent years pay only the annual 1.75 percent fee.
But that still exceeds management fees of as little as 0.2 percent at index mutual funds, and an average annual expense ratio of 1.32 percent at U.S. stock mutual funds, according to Chicago fund researcher Morningstar Inc. Only when measured against funds with big front-end loads of 5 percent or so, do unit investment trusts come out ahead.
Brokers argue that they earn those fees by removing fear and greed from the investment process and by imposing a buy-and-hold discipline. Trusts can’t be compared to broad index funds, they say, because they are smaller and more targeted. They are also far cheaper than building a portfolio independently.
“To own a diversified portfolio that has IBM, Hewlett Packard, Caterpillar and names like that is prohibitively expensive for small investors, or they might only afford one share of each,” says Stanley Craig, director of sales and marketing for defined funds at Merrill Lynch.
Schwab’s first unit investment trust will carry a deferred fee of 1.25 percent, falling to 1 percent in subsequent years. A spokesman says Schwab believes the lower fees will make unit investment trusts more accessible to investors, some of whom have been deterred by high costs.
Liquidity is another thorny issue. August Viekman, a broker with MML Investment Services in South Dennis, Mass., who used to sell fixed-income unit trusts, worries investors might find it difficult to redeem their holdings quickly at a fair asset value in a sudden market correction, despite brokers’ pledges to do so.
“The problem with a fixed portfolio instead of a typical mutual fund is that you don’t have a money manager who’s going to sell any stocks that turn sour,” he says. “The only recourse is the broker’s willingness and ability to redeem the (investors’ trust units), and that hasn’t been tested.”
Tax concerns are easier to tackle. Merrill’s Craig says about two-thirds of the people who buy unit investment trusts keep these holdings in IRAs, where capital-gains taxes aren’t an issue. Those who don’t invest through tax-favored accounts will benefit from a new letter ruling from the Internal Revenue Service, he says. It will allow investors in one-year trusts to roll over some gains if they reinvest in the next year’s trust, Craig explains. They would qualify for the lowest capital-gains tax rate on gains on any stocks that are included in the unit trust for both years, he says.
But Mark Mordoh, a retired theatrical manager in Palm Desert, Calif., worries less about his tax rate than his returns and diversifying his portfolio.
“Without unit trusts, I couldn’t buy these blue-chip portfolio names, only a mutual fund where I’d never be sure exactly what I owned,” says Mordoh, a four-year investor in a Dow Dogs portfolio. Devoting much of his portfolio to chasing small stocks, he adds, “I need that safety net.”
