Fees and More Fees

Marilyn Cohen, Forbes Magazine, 08.09.99

I SUPPOSE I SHOULD STOP being amazed at Wall Street's ability to package new products in ways to add to their fee income stream. Here's the lulu for 1999: unit investment trusts composed of closed-end bond funds. A well-known and successful figure in the industry, Robert Van Kampen, is pushing these things through his wholesale operation, Nike Securities. Brokerage firms such as A.G. Edwards, Salomon Smith Barney and Prudential have selling agreements. Van Kampen founded (and later sold) the mutual fund company bearing his name, and developed insured municipal bond UITs back in the 1970s. They were a good product. But of his latest invention, I can only say: Shame.

These UITs don't offer the usual advantages of investing in a unit trust or the advantages of a closed-end bond fund. A traditional unit investment trust, you will recall, is similar to a closed-end mutual fund in that it has a fixed number of shares that are bought and sold through brokers. Unlike a mutual fund, though, it consists of a fixed portfolio of individual bonds. That minimizes trading costs and management fees. The bonds deliver a predictable income stream and they aren't replaced when they are called or when they mature. For the small investor who doesn't have the money to create a diversified portfolio, UITs make sense.

The new UITs being sold by Nike, under the First Trust brand name, also have fixed portfolios--in a very limited sense. The portfolios consist of shares in roughly three dozen closed-end municipal bond funds or closed-end junk bond funds. During each UIT's trust period, which runs five years, the roster of funds doesn't change, but, of course, each fund continues to do whatever trading it would normally do with its own portfolio. Reich & Tang, a New York broker/dealer and money management firm, is offering a similar product.

So you get a lot of diversification--more than you could possibly need. Meanwhile, the behavior of the products will be inscrutable and there are enough layers of fees to make a wedding cake.

The criteria for selecting funds can be found in each UIT's prospectus. First Trust High Yield UIT, for example, looks for consistent dividend distributions, manager's tenure of more than three years and average Morningstar rating of two stars or better.

It's a pig in a poke. Remember that with traditional bond UITs, the income distribution is known up front--even if the bond market moves way up or way down--with slight variations possible if bonds are unexpectedly called. That's a big advantage for many investors. With these new UITs, expected income is only a rough estimate. It ultimately depends on the performance of each fund's manager and the swings in the market. Plus, you don't know what your principal will be worth at maturity.

As for diversification, does anyone need two or three dozen bond funds? At best, you'll end up with a very expensive closet index fund. Is that the management you're paying for?

Some of the closed-end bond funds represented in the UIT's portfolio will be available at a discount. That's worth something, but you can take advantage of those discounts yourself by buying the funds on the New York Stock Exchange.

Wait, there's more: Closed-end UITs are less liquid than closed-end funds because they trade only once a day, at the market's closing price. With a regular closed-end fund, you can trade any time the markets are open, just as with a stock.

Nike Securities is selling as much as $1.5 million worth of these things per day and expects to take in $200 million on munis and $150 million on junk over the next 6 to 12 months. A Nike spokesman told me that the buyers are investors who are seeking monthly income and want to diversify their closed-end bond fund risk. But wow, what a price they pay.

Besides the ongoing management fees of the underlying funds, there's a maximum sales load of 1% initially plus another 3.5% over the first five months. With a muni portfolio, that pretty much wipes out the first year's income; with junk, the first six months' income. Reich & Tang's UITs are called Municipal Symphony Series II. These products are music to their ears, but not to yours.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

Back to Top