By Brendan Conway

Morningstar analyst Steven Pikelny makes the case against buying Pimco High Income (PHK ) even though Bill Gross closely watched closed-end fund delivers high returns.

It boils down to the massive premium in the share price currently 53%   versus the portfolios net assets:

This fund routinely trades at one of the largest premiums in the CEF universe, hovering around 50% on April 14. It is also one of the highest profile funds of the CEF market, with a market capitalization topping $1.5 billion. Considering that it is run by Morningstar Manager of the Decade Bill Gross and manages to pay a 17.6% distribution rate at NAV, its not difficult to understand why this fund is in high demand.

To be clear, this strategy is not suitable for orphans and widows; Gross routinely utilizes the funds closed capital structure to make concentrated sector bets, take positions with high degrees of duration and credit risk, and use plenty of leverage and derivatives along the way. Its not unusual to see the funds NAV gains or losses reach double digits in a single quarter, but he has produced impressive absolute returns since taking over management responsibilities in 2009. But despite the value that Gross might add to this high-risk strategy, High Income is simply a bad investment at its current premium.

The most obvious disadvantage of buying this fund is its share price risk. A bad year of performance, a Black Swan event, or a negative article in a popular investment publication could lead to extreme levels of short-term volatility (at best) or permanent capital loss (at worst). For example, High Income went on a tear in 2012, posting a 40% return on a NAV basis. However, shareholders actually lost 1.8% that year because the funds premium collapsed from its 73% high in August to 24% by year-end.

The high premium also presents another distinct problem: It significantly eats into investors returns, even if one assumes that Bill Gross will live forever, that he will continue to successfully execute his strategy with no hiccups, and that no negative articles will shatter investor confidence in the fund. PIMCO estimates that the fund is currently earning 16.5% of net investment income at NAV, which means that the portfolio generates an annualized 17.6% in investment income gross of fees (1.06% for fiscal 2013). In other words, the market requires a 17.6% rate of return as compensation for holding the securities in the portfolio. After taking into account fees, the effects of returning capital at a premium. and the premium itself, investors see an earning rate of only 10.6% at share price. This means that shareholders are giving up an annualized 700 basis points of return to hold this fund. Even by hedge fund standards, this is an expensive proposition.

Pikelny argues PIMCO Income Strategy II  (PFN ) is similar enough to serve as a substitute, and this one trades lately at a 2.5% discount .

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