ChuckJaffe

BOSTON (MarketWatch) — Jerry Paul is pleased to be looking for investments that he knows most people ignore or avoid. It leaves more opportunities for him.

Paul, a founder of Essential Investment Partners, a Colorado-based wealth-management firm, is a former Morningstar Fixed-Income Manager of the Year who sees opportunities in closed-end funds that he believes most investors overlook.

The rebounding stock market, increased merger activity, low inflation and possible deflation have combined to create buys in areas most investors wouldn’t think about. Paul’s unique perspective and approach makes him an ideal subject for a series of columns I am writing focused on interviews with outstanding money managers.

Closed-end funds are investments that, effectively, are built like mutual funds but trade like stocks. But where a mutual fund trades at its net asset value — the current worth of all of its holdings divided by the number of outstanding shares — closed-end funds trade based on sentiment. If the market doesn’t think a certain fund is worth its net asset value, the fund will trade at a discount, allowing investors to buy a dollar’s worth of assets for less than a buck.

Special situations

If the market sentiment is likely to change and drive the fund back towards its true value — or even to a premium — investors can turn a quick profit. Throw in the attractive yields on many fixed-income closed-end funds and you have a recipe for high potential returns on low-risk investments.

Opportunities in closed-end funds have been more prolific in the last six to 12 months than I have ever seen, Paul said. I don’t think that will be replicated as we go into 2010, but there are going to still be lots of interesting things. Listen to Paul discuss his favorite closed-end funds.

What Paul typically finds interesting are special situations, cases where activist shareholders are basically trying to force the fund’s board to turn the fund into an open-end issue — immediately raising the price to the underlying net asset value — or to go through liquidation or a buyout for a quick pick-up from a discount. He also looks for convergence trades, where a closed-end fund trades at a bigger discount than normal, making it a cheap buy that is worth holding until the price converges with the norm, turning the oversized discount into cash.

Identifying special situations can be hard, because seemingly every fund has conflict-of-interest issues.

Say a fund gets to where it is selling at a 15% discount, so that an investor can get $1 of assets for 85 cents; a closed-end fund investor would look at that situation and expect a 15% return. In fact, if the fund’s manager can’t generate a return that big elsewhere, he should be buying back shares of the fund (which would help close the gap and turn the discount into cash). Alas, fund managers get paid based on the assets they have under management; when they buy back their shares, their asset size shrinks — along with their own payday — so most managers fight that kind of move until it is forced on them by dissident shareholders.

One of the big challenges in the closed-end space is getting a board of directors, or fund manager to be sensitive to exactly that sort of issue, Paul said. In some cases you have a board of directors that in the face of an activist — which is often what it takes to get something to happen — will fight them for maybe months at a time suggesting. liquidation or tender offer isn’t a good idea for shareholder, only to ultimately come around to that kind of conclusion and offer it up themselves as if it was their idea.

Moreover, those kinds of situations can arise quickly and warrant a closed-end fund investor’s attention.

It does require some homework; it’s not something you just buy and put away, Paul said. Discount alone is not an adequate measure. There are some funds out there with horribly illiquid assets that may even be mispriced, where the NAV may be an error or at least questionable, so you don’t want to buy it just because it has a huge discount. We’re always relating it back to historical discount average, and you have to identify why it will trade back to that or through that. And event, a tender offer, a liquidation, a merger. there needs to be some element.

He added: We’ll buy a fund that doesn’t have anything that’s announced yet on the basis that we know the activists are big holders and are likely to do something and it’s trading above its historic discount.

Paul noted that he’ll be watching closely the fallout from Invesco buying assets from Morgan Stanley, most notably the Van Kampen closed-end funds. The merger deal will require contract approval from shareholders, something that could generate opportunities in those funds, but Paul said it’s the kind of opportunity that bears watching now. See related story.

Money from munis

A big area where Paul sees opportunity right now is in municipal bonds, an arena that was beaten down last year. In general, Paul explained, the real return on bonds (the yield after inflation) is still extremely high. I get people looking at me cross-eyed sometimes when I say that. but if you can identify a municipal bond fund with a 6% tax-free yield on it. that’s attractive.

That’s why Paul is bullish on issues including Nuveen Insured Muni Opportunity NIO, -0.07% Nuveen Premium Income Muni 2 NPM, +0.14% and Nuveen Insured Tax-Free Advantage Muni NEA, -0.44% He also likes and owns several Neuberger Berman muni funds, notably Neuberger California Intermediate Muni NBW, +1.12% and sibling New York muni fund NBO, +0.36%

One area Paul has moved out of is Treasury inflation-protected securities, feeling that the days of bargains on closed-end TIPS funds are gone for now.

Any inflationary risks are some time away, Paul said. We think TIPS are overpriced for inflation expectations; we owned a bunch of TIPS when they traded as if there was going to be deflation, but we have sold those recently as they got overvalued.

We have never found it useful to just kind of buy this stuff and hope it all works, Paul added. Closed-end funds just aren’t for everybody; but there’s a lot to like about them once you understand them