Unit Investment Trusts, Face-Amount Certificate Offices, and Closed-End Management Investment Offices

SIC 6726

Industry report:

The closed-end investment industry consists of investment offices primarily engaged in issuing closed-end funds, unit investment trusts, or face amount certificates. For related information on investment industries, see SIC 6722: Management Investment Offices, Open-End and SIC 6282: Investment Advice.

Industry Snapshot

Unit investment trust (UIT) and closed-end fund (CEF) companies sell shares in securities portfolios. These shares must be purchased when they are initially issued, or afterwards on the open market, and are not redeemable before a designated date. Face amount certificates are essentially obligations of the issuing company to pay a fixed sum at a specified maturity date, and often require periodic payments by the purchaser.

Because shares in this industry's portfolios must be held until a set date, they are not as popular as open-end, or mutual, funds, although they may generate greater earnings. With a stable pool of money, portfolio managers can take more risks in search of profits, often investing in volatile countries and emerging markets. Many closed-end funds, which are traded on stock exchanges, are bargains, because they sell for less than the value of the stocks or other investments that they hold. Funds may also sell for more than their value.

Closed funds are a very small part of the mutual fund industry, accounting for $228 billion in assets at the end of 2009, up 21 percent from year-end 2008 but significantly below the $313 billion in assets at year-end 2007. By comparison, mutual funds had $11.1 trillion in assets. Of all closed-fund assets in 2009, 59 percent were in bonds and 41 percent were equity (24 percent domestic and 17 percent international). About 17 percent of closed-end funds were municipal shares. Overall, closed-end funds assets increased by $85 billion between 2000 and 2009, according to the Investment Company Institute. At the end of 2009 there were just over 657 closed-end funds.

Organization and Structure

Closed-end fund companies are similar to open-end mutual companies in that they both sell shares in a portfolio of actively managed securities. Shareholders benefit from efficient access to professional investment management and from portfolio diversification that they likely would be unable to achieve on their own. Unlike open-end funds, however, CEFs issue a fixed number of shares, which are sold through initial public offerings (IPOs). The money collected through the IPO is invested in securities. After the IPO, shares may not be redeemed until a predetermined date. They must be sold and purchased through a broker on an exchange or through over-the-counter markets.

An important characteristic of a CEF share is that its price is determined by market demand and supply, rather than by the net asset value of the securities represented by the share. CEFs usually trade at a discount to their net asset value, which can vary widely for several reasons. While most CEF shares are traded on the New York Stock Exchange (NYSE), CEFS are also traded on the American Stock Exchange (AMEX) and the National Association of Securities Dealers Automated Quotation (NASDAQ).

After an investment company initiates a CEF, it employs a fund adviser to manage the investment of the shareholders' assets, to conduct research, and to handle administrative tasks. The fund advisory firm is often a subsidiary of the investment company. In fact, the CEF is often established for the purpose of allowing the investment company's directors to earn fees from managing the fund. The adviser's management fee is usually based on the amount of assets in the fund and is commonly set on a sliding scale that declines as total assets increase. Fees of 0.3 to 1 percent of fund assets are common, although some funds offer incentives that are linked to performance. When combined with other fund management costs, operating expenses can consume 10 percent or more of a fund's total income.

Several types of CEFs are offered by investment companies, including equity, bond, and specialty funds. Some portfolios are highly diversified while others emphasize a particular industry or security type. In the early 1990s, about 70 percent of all CEF assets were invested in bond funds. That percentage decreased slightly, to 66 percent, by May 2005, when $172.43 billion of the total $259.65 billion invested in closed-end funds was invested in bond funds. By 2009 only 59 percent of CEF assets were in bond funds. While the primary objective of a CEF that emphasizes bonds is to produce high yields, stock fund advisers seek capital gains. Specialty funds include non diversified CEFs that focus on precious metals, venture capital, utilities, single or multiple countries, single industries, or other investments.

Like CEF companies, UIT investment firms issue shares in a fixed portfolio of assets that cannot be redeemed until a specified date, which is usually between 20 and 30 years after issuance. The shares are traded in the open market until their redemption. Unlike CEFs, however, UITs represent an undivided interest in a unit of specific securities, usually bonds. The trust does not have a board of directors, and the pool of assets is fixed. The portfolio is, therefore, left mostly unmanaged for the trust's duration. The trust distributes the bonds' interest to shareholders until all the bonds mature or are called. UITs are often called defined or focused portfolios.

Because most UIT assets are invested in bonds, UIT participants purchase shares with the expectation of earning a steady, monthly income and then receiving most of their principal back when the shares expire. Investors theoretically get the benefit of holding bonds until maturation without the volatility and risks inherent in short-term trading. Unlike CEFs, or even mutual funds, UIT shareholders know exactly what they are buying. One drawback, however, is that UIT portfolios are unresponsive to changing market conditions. In addition, many UIT holders find that their shares are difficult to liquidate in the open market.

Background and Development

The first closed-end fund was created in Belgium by King William I in 1822. In the 1860s, similar investment trusts were formed in Great Britain. In fact, the Foreign and Colonial Investment Trust, formed in London in 1868, continued to operate in the early 1990s. In the 1880s, British CEFs began investing in the United States to achieve higher returns and diversification. These funds were instrumental in providing capital to finance Civil War reconstruction and to build railroads.

British CEFs led to the development of the Boston Personal Property Trust in 1893, the first American CEF. Excess capital generated during the 1920s caused a boom in CEFs, or investment trusts as they were referred to at that time. Several hundred new funds were formed, including the oldest CEF still in existence today which is General American Investors, founded in 1927. Some 265 new funds were established in 1929 alone, many of which invested in stocks and were highly leveraged.

When the stock market crash of October 1929 rocked financial markets, CEF investors took a beating. One dollar invested in a leveraged CEF index fund fell to a value of about five cents overnight. A positive outcome of the Great Depression for CEFs, however, was critical legislation that served to shape and promote the industry throughout much of the twentieth century. The Securities Exchange Act of 1934 and the Investment Company Act of 1940 became the basis for regulation of both open- and closed-end funds.

Although asset growth in CEFs waned during the 1940s and 1950s, investors began to steadily reinvest during the 1960s and 1970s. Furthermore, the industry began to diversify its offerings. The Japan Fund, for example, became the first American CEF investing in a foreign country in 1962. Convertible funds and corporate bond funds also originated in the 1960s and early 1970s. By 1960, CEFs held about $2 billion compared to only $613 million in 1940. However, by 1970, the industry had expanded its holdings to more than $4 billion. Total assets doubled again during the 1970s, reaching more than $8 billion by 1980.

Even though they were not introduced to U.S. markets until 1961, UITs enjoyed a growth pattern similar to that experienced by CEF companies during the 1960s and 1970s. The first UIT was a municipal securities fund. The industry expanded to include corporate and debt funds in 1972 and government securities funds in 1978. As investors increasingly sought the benefits touted by the UIT industry, assets poured into funds.

The 1980s.
The boom in most financial markets during the 1980s contributed to growth for the closed-end investment industry. At the same time that securities and financial markets were benefiting from increased investment capital, investors were shifting their assets from government regulated bank deposits in an effort to garner higher returns. Often these assets ended up in closed-end instruments or face-amount certificates.

Also contributing to the growth of the industry was a variety of new fund offerings that lured new investors. For instance, "personality funds," developed in the mid-1980s, maintained CEF portfolios that reflected the distinctive investment style of the portfolio manager. Gabelli Equity Trust, the Zweig Fund, and Z-Seven (Barry Ziskin's funds) were all popular personality funds in the 1980s and were still in existence in the late 1990s.

Single-country funds also proliferated in the 1980s. Funds that specialized in investing in Mexico, Korea, Australia, Indonesia, Germany, Turkey, and other countries experienced solid asset growth. The number of convertible bond funds also increased. UITs expanded into new financial vehicles as well, investing in junk bonds, zero-coupon bonds, and real estate.

Industry growth was evidenced by the number of public offerings for new CEFs in the late 1980s. Many of these IPOs were made following the stock market crash of 1987, when weak securities markets pushed many investors into bond funds. Although in 1980 there were no IPOs, and the following year there was only one, there were 26 in 1986, as well as 35 and 62 new issues in 1987 and 1988, respectively. Furthermore, total assets held in CEFs soared from less than $8 billion in 1985 to more than $55 billion by 1990. The number of CEFs grew from just 54 in 1985 to 209 by the end of the decade. UITs grew at a similar pace, encompassing about $130 billion in assets by 1989.

The 1990s.
Many closed-end investment offices experienced steady asset growth in the early 1990s. The amount of money invested in CEFs, for instance, increased nearly 25 percent between 1991 and 1992. Weakened equity markets in the late 1980s, as well as an influx of assets from other financial institutions and investment instruments, were partly responsible for overall industry growth. Despite the success of CEFs and UITs, many investment professionals cautioned against them due to their difficulty to liquidate, lackluster returns, and the high risk involved. However, by the mid-1990s, 18 of the 150 CEFs available had returns on investment of 100 percent or greater.

Although open-end investment offices eclipsed the popularity of closed-end investment instruments, a significant portion of U.S. assets were held by UITs and CEFs in the mid-1990s. For instance, more than $85 billion was invested in CEFs, and about $200 billion in UITs had been sold. The 268 establishments in the United States selling UITs and CEFs were drawing in $388.3 million in revenue and employing 1,104 workers.

However, the industry experienced a slowdown in asset growth during the same period. The saturation of CEF and UIT markets, stronger securities markets that pushed investments into equity instruments, and the growing popularity of open-end mutual funds all contributed to the slowdown. For instance, UIT deposits fell in January 1993 to $819 million, down 12 percent from January 1992. Furthermore, while CEF assets climbed a healthy 35 percent between 1990 and 1992, this was well below the 70 percent growth experienced between 1987 and 1989.

The growing popularity of open-end mutual funds was seen as a threat to many closed-end investments. Many analysts felt that open-end funds, particularly no-loads, offered better returns. In addition, investors' open-end funds benefited from greater liquidity and more active portfolio management than UITs. Indeed, assets in open-end funds had grown about 92 percent between 1980 and 1993, to more than $1.7 trillion compared to the approximately $285 billion held by UITs and CEFs combined.

In the mid-1990s, the largest company in the industry was Meditrust SBI, of Massachusetts. This company had assets of $820 million and employed fewer than 100 people. The second largest company was RYMAC Mortgage Investment Corp. based in Maryland. RYMAC had assets of $564 million in 1992. Likewise, Source Capital Inc., the third largest based on its assets, had no employees and maintained capital of $286 million. The top ten companies in the industry, in fact, employed fewer than 200 people in 1992.

In the late 1990s, the industry saw only modest growth in new assets deposited. Closed-end fund assets increased 5 percent between 1996 and 1997, from $142.3 billion to $150.1 billion, but only 1 percent in 1998, to $151.6 billion. Assets were held by 476 U.S. funds. In 1999, 532 closed-end funds traded on U.S. stock exchanges held $123 billion in assets.

According to the Investment Company Institute, 2.3 percent of all U.S. households owned CEFs in 1998 and 80 percent of them also owned open-end funds. The typical investor had $12,000 in two closed-end funds, the most popular of which were domestic equity and high-yield bond funds. In 1998, for the first time since 1994, investments in foreign securities declined to 18 percent of all CEF assets from 21 percent the previous year.

The value of UITs fared somewhat better than CEFs, increasing 10 percent per year in the late 1990s. Outstanding UITs had a market value of $78 billion in 1996, $86 billion in 1997, and $94.6 billion in 1998. Between 1997 and 1998, UITs added 60 percent in assets, while mutual fund assets dropped 12 percent. In the late 1990s, some UIT companies extended their product lines by joining with insurance companies to offer defined portfolios with the advantages of tax-free annuities. For example, in 1999, Nike Securities and Ohio National Life Insurance Company began offering Nike's Dow 10 UIT as part of Ohio National's ONcore Series of variable annuities.

During the early 2000s CEFs and UITs suffered declines in response to a stagnant economy, a falling stock market, and low consumer confidence. The U.S. economy began a downward trend in March 2001, and after the terrorist attacks of September 11, 2001 fell into a recession. CEF assets declined to $143 billion in 2001, before improving to $159 billion in 2002. In 2003 the economy showed signs of new life, and during 2004 the stock market jumped by 11 percent, adding a strong boost to the economy.

Despite the revived economy by the mid-2000s, UIT assets spiraled downward during the first half of the 2000s, falling from $92 billion in 1999 to just $37 billion at the end of 2004. The number of UITs declined from 10,072 in 2000 to 6,485 in 2004. The drop in UITs was due a significant slowdown in the number of newly created UITs. Almost 80 percent of UITs were tax-free bonds in the mid-2000s. Equity accounted for about 17 percent, and taxable bonds, 4 percent.

In contrast to UITs, by the mid-2000s CEFs had gained significant popularity. Assets increased 26 percent in 2003 to $214 billion and 16 percent in 2004 to nearly $254 billion. There were 620 CEFs in 2004, up from 482 in 2000. Over 50 percent of CEFs were invested in domestic mutual bonds; 22 percent in taxable mutual bonds; 13 percent in domestic equity; 10 percent in global equity; and 5 percent in global bonds.

Exchange-traded funds (ETFs), available since 1993, rapidly increased assets during the first half of the 2000s, from just two in 1995 to 151 at the end of 2004. EFT assets likewise jumped from $80 billion in 2000 to $226 billion in 2004. Although ETFs are registered with the SEC as either an open-ended fund or a UIT, they differ in how shares are issued, redeemed, and traded. An institutional investor creates a specific block of securities and receives a fixed amount of EFT shares in exchange for the deposit. The institutional investor may then trade some or all shares on the stock exchange. Investors may purchase shares, with the price determined by the market, similar to purchasing shares of a publicly traded company. Most ETFs are equity index funds.

In 2005 the SEC suggested a reform to the regulatory measure known as Regulation M that would ban penalty bids. A penalty bid is a financial penalty imposed on investors who sell closed-end funds too soon after an initial public offering. The Investment Company Institute argued that the ban on penalty bids would reduce the industry's ability to stabilize market price in aftermarket trading by controlling a practice known as "flipping," in which investors buy pre-issue stock only to sell immediately after the initial public offering.

The late 2000s saw changes in all areas of the money management industry, as the United States entered a recession many compared to the Great Depression. Hurt by the subprime mortgage crisis and resulting meltdown in the financial services industry, investment offices struggled along with the rest of the economy into 2010.

Current Conditions

Bond funds were the most common type of closed-end fund in 2009. According to the Investment Company Institute, municipal bond funds represented 41 percent of all closed-end funds in 2009. An estimated 2 million U.S. households held closed-end funds in 2009. These investors tended to have much more in financial assets than those who invested in stock or mutual funds. They were also more likely to be retired. The average age of closed-end fund holders was 60 and the average annual household income was more than $100,000. Seventy-two percent of investors were married and 58 percent had a college degree.

ETFs investors were similar to CEF investors in that most also owned stock, were college-educated, and had incomes over $100,000 a year. ETFs had continued to gain in popularity, and by the end of 2009, the total number of ETFs had reached 797, with total assets equaling $777 billion. Ninety percent of ETFs were registered with the Securities and Exchange Commission (SEC).

In 2010, further changes were pending in the industry as participants waited to experience the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July 2010. The act brought about a sweeping reform of the entire financial services industry in the United States. As stated by the Securities Industry and Financial Markets Association (SIFMA), the Dodd-Frank Act involved "an unprecedented two- to five-year rulemaking process where roughly 250 new regulations will need to be researched and written by at least a dozen regulatory agencies." The SIFMA went on to say that although passage of the act "brought to a close the first stage of financial regulatory reform; the rulemaking phase, however, is just beginning. ... the final outcome of regulatory reform will not be known for years in some areas."

Industry Leaders

A few familiar names in the financial services industry remained in the UIT and CEF market in 2010, including Morgan Stanley and Prudential Financial. Several former industry leaders had been bought out and changed names. For example, Van Kampen was purchased by Invesco in 2009; industry leader Paine Webber was merged with UBS AG in 2000, then experienced a name change in 2003 to USB Wealth Management USA. Smith Barney became Morgan Stanley Smith Barney in 2009 when Citigroup sold Smith Barney to Morgan Stanley.

Founded in January 1929, Boston-based Tri-Continental Corporation, with net investment assets of $2.4 billion in 2005, was the oldest publicly traded, diversified closed-end investment company in the United States. The Adams Express Company of Baltimore, Maryland, which was organized as a closed-end fund in 1929, held almost $2.56 billion in total assets in 2005. General American Investors Company of New York was another long-established closed-end fund with $1 billion in assets in 2004. Chicago-based Nuveen Investments Inc. (formerly the John Nuveen Company), which sold ETFs as well as other investments, had 2009 sales of $740 billion and $145 billion of assets under management. Petroleum and Resources Corporation of Baltimore had approximately $500 million invested funds specializing in oil and gas and other natural resource stocks in 2005.

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