Most of us have never seen so many stocks trading at bargain prices. With the clearance rack full of great investment opportunities, why would anyone pay top dollar for investments that can't back up their lofty prices with real value?

Yet that's exactly what some investors in closed-end funds are doing. Although these funds have done well in recent weeks, something's got to give -- and in all likelihood, shareholders will be the ones to pay the price.

Closed-end fund basics
Closed-end funds make up a relatively small portion of the fund market, but they have some unique characteristics that can make them appealing to investors. Unlike traditional mutual funds, which allow shareholders to buy and sell shares on a daily basis, closed-end funds trade like stocks on public exchanges. To buy shares of a closed-end fund, you don't go to the fund company; instead, you need to find a seller on the secondary market who's willing to let you buy shares.

Although that makes closed-ends sound a lot like exchange-traded funds, closed-ends don't act like ETFs, either. ETF companies typically allow institutional investors to create or redeem large blocks of ETF shares, which keeps share values in line with the value of the fund's underlying assets. With closed-ends, however, the fund company mostly stays out of the picture. That can lead to the prevailing share price in the secondary market being much different from the fund's net asset value (NAV).

Paying up for premium funds
Often, you can pick up shares of closed-end funds at a discount to their NAV. For instance, Adams Express, which owns big-name stocks like Microsoft (NASDAQ:MSFT) and Oracle (NASDAQ:ORCL), currently trades at about $0.83 for every $1 of NAV.

But sometimes, closed-end shares trade at huge premiums. Here are some examples of high-premium funds:


1-Year NAV Return

Premium to NAV

Holdings Include

Templeton Russia and Eastern Europe (TRF)



Lukoil, Gazprom

PIMCO High Income (PHK)



Bonds issued by Citigroup (NYSE:C), Ford (NYSE:F), and AIG (NYSE:AIG)

Cornerstone Progressive Return (CFP)



ExxonMobil (NYSE:XOM), General Electric (NYSE:GE)

Sources: Closed-End Fund Association; Morningstar.

Value investors are often seen as trying to buy dollar bills for $0.50. But in this case, these fund investors are paying $1.40, $1.50, or even $1.70 for that same dollar bill. That's not a viable strategy for long-term profits.

Why it happens
Closed-end funds trade at premiums for a number of reasons. For instance, funds that offer access to hard-to-get investments often get bid up above their NAVs, especially when those markets become popular. So in that light, premiums for a fund like Templeton Russia make at least some sense: It's tough for U.S. investors to buy shares of Russian stocks directly on a stock exchange, as many of the fund's holdings don't have American depositary receipts (ADRs) that trade on major U.S. exchanges.

Other funds appeal to investors by offering high dividend yields. The PIMCO fund above, for instance, has a current yield of 17%, while the Cornerstone fund has a whopping 22% distribution yield.

But what many shareholders don't understand is that those large distributions largely come from a return of their own capital. Cornerstone, for instance, owns regular stocks with typical dividend yields in the low single digits; the fund doesn't generate enough income to justify the large distributions it makes. Over time, the fund's NAV has to drop to maintain distribution rates that exceed the fund's true income.

What to do
Eventually, high closed-end fund premiums often fall or disappear entirely, which can make their share value on the open market plummet even when the value of the fund's assets stays constant. It may seem like a natural idea to sell such funds short, but two things make that a risky play: Premiums can persist for a long time, and it can be extremely difficult to find shares available for short-selling, which leaves such funds vulnerable to painful short squeezes.

In general, though, investors should avoid buying closed-end funds trading at a large premium. Premiums create a headwind that will hurt your returns over the long run. You're better off picking up either closed-ends at a discount, or alternatively, ETFs and traditional mutual funds that trade at their net asset value.

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Fool contributor Dan Caplinger gives premium closed-end funds the thumbs-down on CAPS, although he has owned many closed-ends over the years. He owns shares of General Electric. Microsoft is a Motley Fool Inside Value pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never overcharges you.