One of the worst things you can do with your investments is to chase performance. Yet many investors still do it -- even though they usually get burned in the long run.
Below, I'll reveal five top performers that I believe will have to reverse their gains at some point. First, though, let me introduce you to a group of investments that many investors know very little about -- but which have some valuable secrets for those who pay attention.
The hidden world of closed-end funds
Before exchange-traded funds even existed, closed-end funds fulfilled much the same purpose that ETFs do now. Like ETFs, closed-end funds trade on stock exchanges throughout the trading day, giving investors the flexibility to get in and out of positions quickly and on their own timeframe.
But the important way in which closed-end funds don't mimic their ETF cousins has to do with the availability of fund shares for purchase. Most ETFs freely allow institutional investors to buy or sell large blocks of ETF shares to the fund provider, allowing for near-instant liquidity. With closed-end funds, however, there's a fixed number of shares available -- and if you want to buy or sell, you have to find someone on the open market who's willing to take the other side of your trade.
As a result, closed-end fund shares often trade on secondary markets at prices that are far different from the true value of the assets the funds hold. Specifically, with funds that are doing well -- either through high total returns or because of hefty dividend yields -- closed-end funds can fetch premium prices that greatly outpace their net asset value.
The top five closed-ends of 2011
Looking at the best performers in the closed-end realm this year reveals that not all of the activity there is because of performance-chasing. Two of the five best closed-ends are municipal bond funds: one focusing on insured muni bonds nationwide, the other on the niche Build America bonds that the federal government subsidized for a short period in 2009 and 2010. With the municipal bond market having performed better than many had feared -- especially analyst Meredith Whitney -- outpaced returns on munis aren't unique to these leveraged closed-ends.
But for the other three top funds, performance- and dividend-chasing is a lot more apparent. For instance, Gabelli Utility Trust has seen strength in energy plays like Oneok (NYSE: OKE ) and El Paso (NYSE: EP ) , whose shares have jumped on a takeover bid that will eventually mingle its assets with those of Kinder Morgan Energy Partners (NYSE: KMP ) . Yet while the fund shares are up 30%, the net asset value of the fund has barely budged, leaving shares at a 42% premium to NAV -- and its 8% yield, though substantial, isn't nearly enough to bridge the gap.
The same holds true for DNP Select Income and its 7% yield. Here, the net asset value is actually up a few percent, but not close to the 29% jump in price so far this year. Again, an emphasis on utilities like Southern Co. (NYSE: SO ) and telecoms such as AT&T (NYSE: T ) makes this look like a very mainstream investment -- yet the fund shares fetch a premium of almost 40%.
The phenomenon even holds true for investments in preferred shares. Flah & Crum Preferred has actually seen its net asset value decline over the year, with exposure to Banco Santander (NYSE: STD ) , PNC Financial (NYSE: PNC ) and a host of other financial stocks. But investors have bid up the fund shares 28%, likely chasing after its 8% yield.
Don't pay too much
In the coming weeks, you'll probably see a lot about top-performing investments and whether they have what it takes to continue to produce great returns. But before you simply take for granted that great performance will repeat in 2012, take a close look at what produced those gains in 2011. Often, you'll realize that lightning is unlikely to strike twice in the same place.
Our pick for the top stock for 2012 has nothing to do with its past share performance and everything to do with its prospects going forward. Learn all about it in this free special report from the Motley Fool today.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.