By Jim Fink on May 14, 2012

While we all like to analyze individual stocks and invest in those we think can beat the market, it is sometimes wise (and certainly less time-consuming) to hedge your bets and achieve instant diversification through a mutual fund. Closed-end funds (CEFs) are actively managed mutual funds that trade on stock exchanges.

Theyre called closed because they dont accept new investment dollars or redeem existing investment dollars the investment capital is fixed at the time of the initial public offering (IPO). The only way to invest in CEFs after their IPO is by purchasing shares on a stock exchange.

Exception: CEFs may periodically conduct rights offerings that permit current stockholders to purchase additional fund shares directly from the fund.

CEFs dont permit investors to cash out at the funds net asset value (NAV) the per share value of the fund if you were to add up the dollar values of all the individual securities in its portfolio and divide by the number of shares outstanding. Instead, shareholders must sell their shares to other investors on an exchange. Thus, share prices are subject to the psychological whims of investors, and shares often trade at wild deviations from the funds NAV.

Only Invest in CEFs Trading at a Discount

If you wait until a CEF trades below its NAV, you are setting yourself up for a double benefit. Not only can you gain from the capital appreciation of the securities held by the CEF, but you also can profit if the price of the CEF itself moves up toward its NAV. Of course, nothing says that the discount at which a CEF trades cant widen even further, so you should look at the discounts 52-week average to make sure the discount hasnt historically been much greater. A good place to check out a CEFs 52-week average discount is www.cefconnect.com .

The key to successfully investing in CEFs is to buy them when they are selling at a discount to NAV. Of course, as with stocks, its important to investigate why theyre on sale and find out if youre really getting a bargain. Some CEFs trade at a discount because investors lack confidence in the management team, there is a large unrealized tax liability, or the fund employs high-risk leverage, so it is important to do your due diligence, just as you would with any investment. In other words, a CEF trading at a discount to NAV does not automatically mean that it is a bargain.

Stay Away from CEFs Trading at Premium

In contrast, a CEF trading at a premium to NAV is almost never a good investment. Premiums exist due to investor speculation or confidence in the investment prowess of the manager. For example, bond funds managed by PIMCO often trade at a premium because investors respect PIMCOs bond trading prowess. I once shorted a PIMCO CEF trading at a double-digit premium only to find it expand to an even greater premium. I didnt enjoy that experience, so I am hesitant to short CEFs trading at a premium (especially any managed by PIMCO), but I still wont buy them either.

Investing Dailys Ben Shepherd is not a fan of CEFs for a couple of reasons:

Closed-end funds are burdened with two significant disadvantages.

The most obvious problem is pricing. Regardless of the quality of the bonds making up a closed-end fund, because shares trade just like any other stock, they often change hands at substantial premiums or discounts to their net asset value (NAV). Unless youre engaging in a bit of arbitrage or making a speculative bet on the recovery of specific areas of the bond market, thats a disadvantage to investors.

Theres also the issue of leverage. Closed-end funds have a long history of issuing preferred shares and auction rate securities (ARS) in order to juice the returns they offer investors. That can be attractive in bull markets, with positive returns amplified by the leverage. But in down markets plunging share prices are just as exaggerated. And closed-end funds arent always as transparent on this issue as they should be.

Focus on CEFs with Low Expense Ratios

Another important factor to consider is the CEFs expense ratio, which includes management and marketing fees. Fund performance is uncertain, but fund expenses are predetermined, so investing only in CEFs with modest fees is a smart way to reduce your risk. Theoretically, CEFs should have lower expenses than open-ended funds because CEF managers have a captive investment base and dont have to worry about redemptions which can add to trading costs. In reality, I have found many CEFs charge exorbitant fees either because their funds asset size is too small thus forcing a higher percentage of fixed costs to be absorbed per investment dollar or because they unethically take advantage of the captive investment base, knowing that redemptions are impossible.

Buying CEFs at Their IPO is a No No

Never buy a CEF at the time of its initial public offering (IPO). Brokers often tout CEF IPOs as commission-free, but what they dont say is that the offering price includes an embedded sales charge, resulting in a price that is around 5% higher than the funds NAV. For example, many CEF IPOs are offered at a price of $20 with an initial NAV of between $19.00 and $19.10. Buying $19 worth of assets for $20 is not a smart way to invest, especially since academic studies have shown that the typical CEF loses 8% of its value in its first 100 days of trading and 12.6% in the first five months.

A 2004 study by Thomas J. Herzfeld Advisors drew this conclusion about CEF IPOs:

Investors in IPOs of closed-end funds rarely make money just after the offering: In fact almost all investors wind up underwater over the short term. But there is often a lot of money to be made by buying the new issues three to six months after launch for two reasons: There is usually a lack of research on these issues and many are dumped for tax losses toward the end of the calendar year.

List of CEFs Worth Considering

Below is a list of CEFs that pay at least a 5% annual dividend, are trading at a discount to NAV of at least 8%, and charge no more than 1.25% of assets in non-leveraged management expenses. They are not recommendations, but merely a starting point for further research.