RiverNorth’s Galley, left, and Schmucker (Photo credit: Andy Goodwin)

Wall Street is full of anomalies. And then there are closed-end funds, the granddaddies of today’s mutual fund business, first created in the U.S. in 1893. These exchange-traded investment companies display behavior that is so squirrelly, so irrational, that professional managers can make money by betting against retail investors who clearly don’t have a clue what they are worth.

RiverNorth’s Brian Schmucker and Patrick Galley have built a $2.3 billion firm on this idea. They buy closed-end funds when investors have pushed them down to crazy lows and short them when they are priced irrationally high.

“It’s a beautiful thing for us,” says Galley, 36, who joined RiverNorth in 2004 after working as an investment banker to closed-end funds at Bank of America. Irrational pricing, he says, is “what we’re taking advantage of.”

The only thing RiverNorth can’t take advantage of is the oddest quirk of all: Investors willingly pay 100 cents on the dollar for newly issued funds that are worth only 95 cents after subtracting underwriting fees and commissions. But underwriters won’t lend those shares for the first couple of months on new issues, making shorting them virtually impossible.

There are plenty of other ways to make money, however. Income funds, for example, are trading at steep premiums to the value of their underlying assets as investors grasp for yield. Pimco’s $1.3 billion High Income Fund is trading at a 36% premium to asset value, meaning investors are willing to pay $1,360 for $1,000 worth of securities to get their hands on the fund’s 10.45% yield.

Those premiums tend to ratchet up because of another odd habit of retail investors: They ignore the effect of dividend payouts. If a fund is trading at a 50% premium, it should drop by $1.50 after paying a $1 dividend. Anything less and the premium ratchets up, which is one way fixed-income funds wind up trading at nonsensical premiums. In July the Pimco fund peaked at a 77% premium to asset value before investors wised up and started selling.

Retail investors also drive some funds to irrational lows. The $1 billion Tri-Continental fund is trading at a 15% discount, meaning investors who buy now get $1,000 worth of stocks, including Apple. Microsoft and Pfizer, for $850.

“If you’re going to own equities, why wouldn’t you buy them at a discount?” Galley asks.

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One reason is that the discount might get bigger. Closed-end funds, unlike mutual funds and ETFs, sell a specific number of shares and then let the market decide what they’re worth. They don’t have built-in adjustment mechanisms that allow arbitragers to demand the underlying assets if the discount gets too wide. The only sure way to drive a closed-end fund closer to its net asset value is to attract a raider who tries to force management changes or a liquidation.

Schmucker, a Pittsburgh native who graduated from Penn State, started a chain of bagel shops with some of his childhood buddies. That brought him in contact with a finance professor who persuaded him to give up on his bagel idea. He formed RiverNorth in December 2000, and despite having no prior money management experience, quickly built it up to $100 million in assets.

“I’m the entrepreneur, more the coach,” he says.

Schmucker hired Galley in 2004, and the two began trading closed-end funds for their clients. They quickly realized they could build a bigger business around the strategy, which is well known but underexploited. “There’s not a lot of investment managers who have the time and energy to trade” closed-end funds, Schmucker says.

RiverNorth launched its first open-ended fund, Core Opportunity, in 2006. It has since grown to $569 million in assets, with a nearly 8% annual return versus 2.5% for the S&P 500. It closed to new investors in July 2011. The firm’s fixed-income version, launched in December 2010, combines RiverNorth’s closed-end strategy with a bond portfolio managed by DoubleLine’s Jeffrey Gundlach. It closed last March.

RiverNorth’s latest fund is a collaboration with Rochester, N.Y.’s Manning & Napier, which picks large companies with high free cash flow and dividends and mixes in a healthy slug of closed-ends.

Trading closed-end funds isn’t just a matter of shorting the pricey ones and buying the cheap ones. “You really can’t just look at them purely on a fundamental basis,” Galley says. Investors get confused and sell indiscriminately during market downturns, for example.

Most funds should trade close to their five-year average discount or premium, Galley says. Many funds use borrowed money to leverage higher returns, but that can cause the price to collapse if managers are forced to cut the dividend. There are also closed-end funds that pay out part of the distribution as a return of capital–handing investors back their money, in other words. That’s a bad thing when the fund is trading at a premium but can be good if it’s trading at a discount, since you’re buying assets on the cheap and selling them for cash at par.

Galley also takes advantage of investor cluelessness when funds announce a “corporate action,” which is buying back shares at net asset value–”free money,” he says, for investors who bought the fund at a discount.

RiverNorth is not immune to downturns. Its equity-focused Core Opportunity Fund plunged 28% along with the rest of the market in 2008. The silver lining was many closed-end funds fell 50%, presenting a golden opportunity for RiverNorth. Core Opportunities rose 49% in 2009 and another 18% in 2010.