Using Unit Investment Trusts to Outperform the Market

By Shimshon Plotkin, CFP®, CFS

Advisors looking to provide the best investment management service to their clients are often faced with two primary challenges: How can you manage equity portions of client portfolios in a diversified, rebalanced and systematic way in order to keep up with market-style shifts? And, how can you manage client assets such that a clear performance added-value can be demonstrated aside of the obvious drive for service excellence?

In an attempt to address the challenge of keeping up with occasional market-style shifts, I sought to create an "all weather" portfolio that is conservative in nature, dominated by the value style of investing, while maintaining a robust performance potential. The intriguing simplicity of Warren Buffet's investing approach led me to unit investment trusts, or UITs. A UIT is a fixed portfolio of securities held for a predetermined time. Investors purchase units, which represent an undivided ownership in the securities contained in the portfolio. The well-known Buffet concept of buying very good stocks and holding them with little attention to short-term fluctuating stocks prices fits well within the UIT platform.

To resolve the second challenge of being able to provide performance added-value, I selected five unit investment trust strategies, combining them into one portfolio.

First Trust Portfolios, L.P. provided me with the flexibility of solving for an optimal risk/return ratio through the use of many hundreds of varied portfolio allocation permutations. After seven years of design work, the resulting UIT, called the Georgetown Capital Appreciation Portfolio™, has addressed the above concerns beyond my expectations.

In this article, I will explain the logic behind using a unit investment trust structure and show why this particular portfolio (see sidebar for details) has had the tendency of producing a near 20 percent annual rate of return while maintaining a standard deviation that is in line with the S&P 500 (see Figure 1).

The Method to the Madness

While the optimal percentages for each UIT strategy that I'm using are fixed, the sectors and styles are unhindered variables, thus minimizing limitations on performance. The selection of UIT strategies creates a unique double-blind stock selection process dominated by a computerized screening process that produces fluid sector and style weightings.

In four of the five strategies (the growth strategy being the exception), stock selection is a two-step process. We start with a universe of the best companies provided by Value Line®, Standard & Poors, Dow Jones and the NYSE and distill them down to 175 stocks that represent the best screened companies at reasonable prices that also show some early appreciation momentum. This selection process repeats itself every 15 months. We create a new portfolio every quarter so that the first three months are open for new investors, then the portfolio remains closed to new investors until it expires at the end of 12 additional months. This approach minimizes the common practice of replacing a stock after its gains start to stall. In fact, a stock is replaced even if it continues to appreciate, if a better potential performer is available.

Based on the above, we have used UITs to create a portfolio that is diversified, follows a consistent stock selection process, systematically rebalances every 15 months and contains a defensive value style bias through fundamental analysis for greater safety.

Using a UIT chassis to build a portfolio has many benefits. It allows you to gain control over capital gains taxes so current investors do not pay taxes on other investors' gains. When an investor stays invested for the 15-month duration, you can eliminate short-term gains altogether. You can also eliminate performance drag that is a result of the constant need for cash reserves and style drifts that are a result of managers chasing returns.

One thing to keep in mind about UITs is that when the trust matures, clients may take the securities in kind, incurring capital gains on their shares. If clients choose to invest their proceeds in another UIT, or choose to do nothing, either will trigger a taxable event. Also, because UIT holdings are not removed based on price movement, a holding will generally remain in the portfolio regardless of its market value. However, in extreme circumstances, holding can be eliminated for credit reasons.

Putting UITs to the Test

I have been using this UIT portfolio for the equity portion of my clients' portfolios for a number of years, and we have consistently outperformed the S&P 500 annual returns. Considering that the annualized internal costs are approximately 75 bps, the total client cost, including management fees and internal costs, vary between 1.25 percent and 2.00 percent.

U.S. Treasuries, or TIPs, are used to control various risk levels, providing readily available bonds that mature with the periodic expiration of the UIT. The Treasury portion of the allocation provides principal guarantees and generates income free of state taxes. Additionally, the simultaneous expirations of the Treasuries and the UIT eliminate rising interest rate risks and provides for systematic 15-month cycle portfolio rebalancing.

Because portfolio expiration dates occur only at the end of each fifth quarter, rebalancing is simple as we know which set of client assets will mature and will be rebalanced at the start of each quarter. The stock-selection process provides the comfort that stock market volatilities and the occasional swift downturn have a high probability of full recovery; and that is something advisors and clients alike can appreciate in today's market.

Shimshon Plotkin, CFP®, CFS, is president of Plotkin Financial Advisors LLC in Chevy Chase, Md. He can be reached at 301-907-9790 or splotkin@pfallc.com.

A Look Under the Hood

Aided by First Trust Portfolios' back-testing capabilities, I was able to systematically produce the optimal combination of UIT strategies, which combined into one UIT are referred to as the Georgetown Capital Appreciation Portoflio™. The five strategies, their screens and percentages in the portfolio are as follows:

The Dow® Target Dividend Strategy: 20 percent

• Rank each of the 100 stocks that comprise the Dow Jones Select Dividend IndexSM on two factors: greatest change in return on assets over the last 12 months and price to book.
• Purchase an approximately equally weighted portfolio of 20 stocks with the best overall ranking of the two factors.

Value Line® Diversified Target 40 Strategy: 15 percent

• Begin with the 400 stocks that Value Line® currently gives No. 1 or No. 2 ranking for Timeliness™.
• Eliminate all foreign companies and select only socks with a market capitalization of more than $2 billion.
• Rank the remaining stocks on three factors: sustainable growth rate; price to sales; and price to cash flow.
• Purchase an approximately equally weighted portfolio of the 40 stocks with the highest combined ranking on the three factors, subject to a maximum of eight stocks from any one of the 10 major market sectors.

NYSE International Target 25 Strategy: 15 percent

• Screen the stocks that comprise the NYSE International 100 IndexSM for liquidity by eliminating companies with average daily trading volume below $300,000 for the prior three months.
• Rank the remaining stocks on two factors: price to book and price to cash flow.
• Purchase an approximately equally weighted portfolio of the 25 stocks with the best overall ranking on the two factors.

S&P Target SMID 60 Strategy: 25 percent

• Rank the stocks that comprise the S&P MidCap 400 and the S&P SmallCap 600 Indices by price to book value.
• Select the best quartile from each index.
• Rank each remaining stock on three factors: price to cash flow; 12-month change in return on assets; and three-month price appreciation.
• Eliminate any stock with a market capitalization of less than $250 million and those with an average daily trading volume of less than $250,000.
• Select the 30 stocks from each index with the best overall ranking on the three factors. The stocks selected from the S&P MidCap 400 Index are given approximately twice the weight of the stocks selected from the S&P SmallCap 600 Index.

Target Growth Strategy: 25 percent

• Begin with all stocks traded on a U.S. exchange and screen for the following: minimum market capitalization of $6 billion; minimum three month average daily trading volume of $5 million; and minimum stock price of $5.
• Eliminate REITs, American Depositary Receipts, Registered Investment Companies and Limited Partnerships.
• Select only those stocks with positive one-year sales growth. Rank the remaining stocks on three factors: sustainable growth rate; change in return on assets; and recent price appreciation.
• Purchase an approximately equally weighted portfolio of the 30 stocks with the highest combined ranking on the three factors, subject to a maximum of six stocks from any one of the 10 major market sectors.