Few investment instruments available on the open market are more misunderstood than closed-end funds, perhaps because at only $150 billion the entire closed-end fund universe does not command a great deal of attention. But investors who recognize a few key aspects are in a position to both capitalize on their unique properties, such as attractive dividends, and avoid the traps that can occur in this space.

For instance, investors have returned to the yield chasing mindset of early 2007, a trend that’s particularly prevalent in the closed-end funds arena. Many funds with aggressive distributions are trading above historical levels in a total disregard for risk. Interestingly, a near record number of closed-end funds are still trading at very cheap levels, several of which offer attractive yields themselves.

The lesson: Start by looking for those closed-end funds that are priced lower than their historic discount and avoid funds trading at a premium.

Interestingly, the right closed-end funds make great candidates for absolute return portfolios, which have increased in necessity given the market’s propensity for unpredictability over the past 18 months. So how do you actually generate profits without theoretically risking market exposure?

There is a lot to be said for employing a straightforward approach. First, research and locate closed-end funds with attractive yields that are trading at healthy discounts to their historical range, and then perform the necessary due diligence to find out why. Look for funds that can be expected to close the gap toward their historical range while investors achieve attractive distributions.

As far as neutralizing equity risk, investors will have to calculate each fund’s beta (correlation to the market). Using a beta calculation, investors can essentially employ a discount arbitrage strategy. This, in effect, allows investors to keep the fund’s yield and any potential market outperformance, but hedges out its associated market risk.

This brings up an interesting point. Strong absolute return portfolios are built on strong underlying funds, which rely on strong fund managers. One of the best strategies for locating strong fund managers–not just for closed-ends but any mutual funds–is the snapshot approach. A fund manager’s long term track record is no doubt important, but depending on the current market cycle it pays to look at snapshots of how a fund manager performs at the onset of past rallies or bear markets rather than over an extended period of time. The snapshot approach can give investors a good expectation for a fund’s performance during different market environments.

Some funds that Relative Value Partners is currently focusing on are:

NFJ Dividend, Interest & Premium Strategy is primarily comprised of domestic equities that pay dividends. The fund can also invest a portion of its assets in convertible bonds (24% as of June 30) and will write (sell) covered-calls to generate income.

Following NFJ’s sizable dividend cut in March, the fund has been trading around a 20% discount to NAV. While the yield (4.5%) is below its peers, the average covered-call fund is trading at a 2.4% discount. We expect over time, NFJ will trade more in-line with its peers.

SunAmerica Focused Alpha Growth is a domestic equity fund with a focus on growth stocks. The fund uses subadvisers that include some of the most famous names in growth investing, such as Tom Marsico and Ron Baron. The fund trades near a 17% discount to NAV even though posting an impressive 23% NAV return year-to-date. The fund holds no more than 40 positions, two-thirds in large cap stocks and the remainder in mid- and small-cap companies.

Besides the steep discount and superior stock picking ability of this fund’s managers, we believe FGF also has a unique catalyst that could cause the fund’s discount to tighten drastically. SunAmerica is a wholly owned subsidiary of AIG. We speculate that a potential sale of SunAmerica by AIG could cause activist investors to attempt to have the fund converted to a traditional open-end mutual fund or take other measures to allow investors to redeem their shares at NAV.

MFS Multimarket Income Trust is a non-levered multi strategy fixed-income fund comprised of high yield bonds, emerging market debt, investment grade corporate bonds, and U.S. treasuries. The fund currently yields 7.5% and trades at near an 8% discount to NAV.

Despite already having a strong YTD performance of 34%, we believe MMT can still provide attractive returns going forward. Given the fund’s large distribution and unlevered status, we see it warranting tighter discount levels and having the potential to provide a stable level of income in a placid equity environment.

Maury Fertig is chief investment officer at Relative Value Partners in Northbrook, Ill. a registered investment advisor with $350 million in assets under management.