What it means
Most funds are actively managed, which means the manager buys and sells holdings as views and markets change. A defined portfolio works the other way round.
The sponsor selects a list of securities, such as bonds of a particular type or shares meeting set criteria, sells units to investors, and then holds that list until the trust terminates. The fixed nature gives investors clarity.
They can see the holdings from day one, and the sponsor cannot drift into different investments later. In a bond portfolio, the maturity dates of the holdings are known, so investors can plan roughly when their capital will be returned.
Costs and trade-offs are different from those of an actively managed fund. Because there is little trading, ongoing costs can be low, but there is usually an upfront sales charge.
The portfolio also cannot react if one holding deteriorates, apart from limited circumstances set out in the trust document, such as the issuer defaulting. Defined portfolios suit investors who want a known mix of assets and a known end date, for example someone saving for a spending goal in five years.
They are less suitable for people who want a manager to respond to markets. Liquidity is also a consideration: units can typically be redeemed or sold, but the price depends on the value of the underlying holdings at that time.
For a finance team, the concept is also a useful model for how to treat a surplus cash investment. Setting a fixed list of permitted instruments and maturities in advance is a form of defined portfolio, and it makes the investment policy easy to audit.
One more point to watch is concentration. Because the list is fixed, a handful of large holdings can dominate the result, and the sponsor cannot rebalance.
Reading the list of holdings and their weights before buying is therefore the single most useful step.
In practice
Real-world examples.
Example
A retired teacher buys units in a defined portfolio of municipal bonds that mature over the next six years. She knows what the trust holds and when each bond is due to repay, so she can plan her income. Because no trading happens inside the trust, she also receives a clear statement of what each holding contributed.
Example
A family office invests in a defined portfolio of large dividend-paying companies selected at the start of the year. The portfolio is held without changes until it ends, giving the office a fixed strategy. The investment committee finds it easier to explain a fixed list to family members than a manager's changing views.
Example
A corporate treasurer sets a written policy that surplus cash can only be held in a defined list of government securities with maturities under one year. The list works like a defined portfolio and is simple for auditors to review. Any request to hold something outside the list must go to the board first.
Formula
Calculation
Net asset value per unit = (total value of holdings - liabilities) / number of units
A defined portfolio holds securities worth $20,150,000 and has $150,000 of accrued fees and expenses owing. Net assets = $20,150,000 - $150,000 = $20,000,000. With 40,000 units in issue, the net asset value per unit is $20,000,000 / 40,000 = $500. An investor holding 100 units therefore has a share worth 100 x $500 = $50,000.Case study
Seen in the real world.
Winterbourne Capital is an illustrative, fictional sponsor that created a defined portfolio of twenty investment-grade corporate bonds maturing within five years. It sold 40,000 units at $500 each, raising $20,000,000.
During the first two years, one of the issuers ran into trouble and the trust document allowed the trustee to sell that bond. The proceeds were distributed to unit holders, and the rest of the portfolio continued unchanged.
Winterbourne is a made-up company, so the figures are for teaching only. Investors valued the predictability, but the finance director explained that they had to accept being unable to swap bonds when conditions changed. The trust paid out interest every six months, and the final distribution came when the last bond matured.
Watch out
Common mistakes.
- Assuming a defined portfolio is actively managed, when its holdings are fixed at the outset.
- Ignoring the upfront sales charge, which can be significant relative to the low ongoing costs.
- Forgetting that the value of units can still rise and fall, even though the holdings are known.
Questions
People also ask.
How is a defined portfolio different from a mutual fund?
A typical mutual fund has no end date and its manager trades regularly, whereas a defined portfolio has a fixed list of holdings and a set termination date.
Can investors sell before the end date?
Usually yes, units can be redeemed or sold, but the price depends on the market value of the holdings at the time.
What happens at the end date?
The remaining holdings are sold or mature, and the proceeds are distributed to unit holders in proportion to their units.
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