Great Investments You've Never Heard Of

Smart investors know that some of the most successful investments hide in places that most people overlook. Discovering those investments isn't always easy, but the rewards often make up for the extra effort.

The same principle applies to mutual funds as well. While fund investors focus their attention on traditional mutual funds or exchange-traded funds, closed-end mutual funds have remained a neglected part of the fund universe.

This month's issue of the Fool's Champion Funds newsletter service, which hits the digital presses this afternoon at 4:00 ET, takes a closer look at closed-end funds. As lead analyst Amanda Kish describes for her readers, closed-end funds have some advantages that regular mutual funds and ETFs don't have -- but they also come with their own risks.

How closed-ends work
In many ways, closed-end funds resemble any other mutual fund. The fund owns an assortment of stocks and other investments in its portfolio, and shareholders each own a proportional share of those assets. Once a day, the fund determines its net asset value (NAV) and lets you know how much intrinsic value your fund shares have.

But the similarities end there. Regular mutual funds continually offer new shares and buy back old ones at net asset value. Likewise, ETFs let institutional investors make transactions directly with fund managers to buy or sell large blocks of ETF shares.

However, as Amanda observes in her newsletter, closed-end funds don't trade shares directly with investors on a regular basis. Instead, fund managers sell shares only occasionally through public offerings. Then, shareholders who want to buy or sell have to trade with each other on stock exchanges.

Strange behavior
One interesting consequence of having only limited numbers of shares is that the share price of a closed-end fund in the secondary market can vary widely from the fund's net asset value. Some closed-ends trade at a premium to NAV, and others are available at a discount.

Often, there's no apparent reason for the premium or discount on closed-end shares. For instance, take a look at some key points for two closed-end funds: Cornerstone Total Return (CRF) and Adams Express (ADX).

Sources: Closed-End Fund Association, Morningstar.

Both of these funds have remarkably similar portfolios -- especially when you consider that Adams Express holding Petroleum & Resources is itself another closed-end fund whose top two holdings are ExxonMobil and Chevron. Looking at NAV-based returns, we see that Adams Express has had slightly better performance both this year and over the past five years.

But looking at how the actual closed-end shares have performed on the secondary market shows a much different picture.

Sources: Closed-End Fund Association, Morningstar. Five-year returns are annualized. The most recent data for CRF is as of July 18 and for ADX as of July 22.

Surprisingly, the Cornerstone fund trades at more than double its NAV. Adams Express shares, meanwhile, sell at a big discount. Why the discrepancy?

Small markets are inefficient markets
One likely explanation comes from the funds' dividend payouts. Cornerstone pays monthly dividends that currently give the fund a 16.5% yield. Adams Express acts more like a traditional mutual fund in paying small quarterly dividends with a larger capital-gains distribution late each year.

That 16.5% yield looks awfully attractive, especially with interest rates languishing. But because the fund hasn't come close to that rate of return within its portfolio -- its five-year NAV return is less than 5% annually -- much of that yield has come simply from giving shareholders back their original investment.

Ordinarily, arbitrage traders would swoop in to take advantage of this disparity. The problem, however, is that these funds are relatively small and thinly traded, so imbalances can last for years. The Cornerstone fund has been trading at a premium ever since 2003, and over much of the past two years, the premium has been more than 50%. Although the premium will almost certainly fall without better fund performance, how long that may take is anyone's guess.

To learn more about closed-end funds, along with a few specific closed-end funds you might want to look at, take advantage of our free trial offer to see this month's issue of Champion Funds. You'll also get full access to loads of advice on how to survive the bear market, in addition to discussions with top fund managers and our fund picks of the month. If you own mutual funds, you owe it to yourself to pick up the new Champion Funds issue today.

To learn more about using mutual funds to profit, read about:

• The reason you shouldn't turn your back on stocks.
• The easy way to own the hottest stocks in the world.
• Some guidelines for investing in a bear market.