Swedroe: Costs Undermine Active Investment

Unit investment trusts (UITs) are SEC-regulated investment vehicles in which a portfolio of securities is selected by a sponsor and then deposited into a trust. Assets held in UITs have grown steadily since the financial crisis, increasing from about $20 billion at the close of 2008 to about $87 billion by the end of 2013.

At that time, of the more than 5,000 UITs in existence, fewer than half were classified as equity trusts. Equity UITs, however, held more than 80 percent of UIT total net assets. Most UITs are part of a trust series. A new trust in the series can be issued while the previous trust still exists, or after the previous trust in the series has terminated.

Unlike mutual funds, equity UITs invest in a fixed portfolio of stocks for a predetermined period of time. Equity UITs typically terminate within five years of their launch date. Many terminate within one year.

Also unlike mutual funds, UITs hold very limited cash positions because they don’t have to meet redemption needs. The lack of a “cash drag” gives UITs an advantage. And their lack of turnover helps keep total costs down.

The fixed (buy and hold to termination date) portfolio of UITs provides a unique sample for measuring stock selection skill. George Comer III of Georgetown University and Javier Rodriguez of the University of Puerto Rico—authors of a May 2015 paper, “Stock Selection Skill, Manager Flexibility, and Performance: Evidence from Unit Investment Trusts”—studied the performance of 1,487 UITs over the period 2004 to 2013.

UIT Expenses

There are two main types of expenses connected to UITs. The first is the maximum sales charge associated with purchasing the trust. The maximum sales charge is composed of an initial sales charge, a deferred sales charge, and creation and development fees. These sales charges are relatively consistent across trusts, averaging a total of 3.14 percent.

The second is the estimated annual trust operating expense, which includes costs associated with portfolio supervision, bookkeeping, evaluation fees and trustees’ fees. These costs are also relatively constant across trusts, averaging 0.23 percent.

Before reviewing the authors’ findings, it’s important to note that UITs start to sell securities in connection with the trust’s termination beginning nine days prior to the actual termination date.

The Price Of Selling Positions

The trust determines the manner and timing of the sale.

Trust prospectuses acknowledge that, given the requirement to sell their securities within a relatively short period of time, the sale of those securities may result in lower sales prices than otherwise might be realized.

This mandatory sale may have a negative impact on trust performance that is not reflective of skill. Because the study is meant to examine the stock selection skills of the UIT managers, all of the calculations in the study exclude returns from the nine business days prior to termination.

However, it’s important to note that investors would bear any market impact costs.

UIT Benchmarks

In analyzing the performance of UITs, Comer and Rodriguez compare their returns to four benchmarks.

• The first is the single-factor (beta) CAPM model.
• The second is the four-factor (beta, size, value and momentum) Carhart model. That’s because the UITs they studied had on average roughly 12 percent of their holdings in international stocks.
• The authors used a third model, adding an international index (the MSCI World ex U.S. Index) to the Carhart model. The fourth model is a trust-specific benchmark, such as a Dow Jones sector index.

Conclusions

Following is a summary of their findings:

• Regardless of the model employed, UITs generated significant negative alphas of between -2.5 percent and -2.8 percent.
• More than 65 percent of the UITs studied generated negative alphas.
• There were four times as many trusts with negative and significant alphas than there were with positive and significant alphas. Given their expense ratios of about 0.23 percent, expenses don’t explain the negative alphas of UITs.
• None of the trust series were able to generate significantly positive alphas at the 5 percent level of significance.
• Poor performance was consistent across asset classes. The average alphas all were negative.
• The financial crisis was not a main driver of the negative alphas.
• UITs significantly underperform mutual funds, suggesting that restricting flexibility and maintaining full investment in the market doesn’t result in better risk-adjusted performance.
• Observable trust characteristics, such as trust size and expenses, weren’t able to explain the poor performance.
• There was no evidence that the inability of UITs to trade was the main driver of results. UIT performance slightly improved during the life of the trust.
• Poor performance persists within trust families. Focusing on the Carhart model results, the average primary trust alpha was -2.8 percent and the secondary trust alpha was -2.9 percent. Both of these estimates are statistically significant at the 1 percent level.

Gathering Evidence

Comer and Rodriguez conclude that their tests suggest the negative alphas of UITs reflect poor stock selection skill.

This is an interesting finding, and one that’s very different from the evidence on actively managed mutual funds. While the studies on individual investors have found that they also exhibit poor stock selection skills, this isn’t true for mutual funds.

For example, a paper by Russ Wermers—“Mutual Fund Performance: An Empirical Decomposition Into Stock-Picking Talent, Style, Transactions Costs, and Expenses,” which was published in the August 2000 issue of the Journal of Finance—found that on a risk-adjusted basis, the stocks’ active managers selected outperformed their benchmark by 0.7 percentage points per year.

Expenses Bury Alpha

Unfortunately for investors, stock picking alpha wasn’t close to enough to generate alpha after expenses. Total costs, including the cost of “cash drag,” exceeded 2 percent.

The evidence makes it clear that UITs are another security in a long list of products meant to be sold (because of their high embedded sales charges) but never bought.

The bottom line is that whether we are looking at UITs or actively managed mutual funds, investors are more likely to achieve their goals by limiting their investments to passively managed vehicles.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.