The first exchange traded fund to come to market, and today the most actively traded ETF, the SPDR S&P 500 ETF (SPY), was structured as a unit investment trust (UIT). In simple terms, a unit investment trust is an investment vehicle which purchases a fixed portfolio of securities, such as municipal or government bonds, mortgage-backed securities, common stock or preferred stock.
The way they work is that the trust purchases the securities and then markets and offers shares of the trust to investors through brokers. Unit holders of the trust receive an undivided interest in both the principal and the income portion of the portfolio in proportion to the amount of capital they invest.
UITs offer transparency in that their portfolios are selected at the time of deposit and they don’t change until the trust matures. However, holdings in the trust can be eliminated under extreme circumstances such as deterioration in credit quality, fraud or other irregularities. They are tax efficient and offer low costs because there is little to no trading activity in the trusts.
To further dissect a UIT, take a look at the above mentioned SPY. This security represents ownership in a long-term unit investment trust that holds a portfolio of common stocks designed to track the performance of the S&P 500 Index. In addition to capital appreciation, owning shares of this trust entitles the holder to receive proportionate quarterly cash distributions corresponding to the dividends that accrue to the S&P 500 stocks in the underlying portfolio, less trust expenses.
To sum it up, a UIT offers many of the same benefits and characteristics of a run-of-the-mill ETF, but one owns shares of the trust and not that of the actual basket of securities.