At the end of each year, it's always interesting to look at the investments that performed the best during the previous year. Among domestic stocks, land developer and magazine distributor Amrep (NYSE:AXR) and network application developer Internap (NASDAQ:INAP) topped the list of best returns for 2006, along with a typical broad mix of companies spread out across several different industries. Moreover, in the international investing realm, finding great returns wasn't all that hard. As Bill Barker points out in his article on strong buys and international stocks, many countries spanning the globe had average market returns that outperformed the domestic stock market here in the United States. From emerging powers like China, India, Brazil, and Russia to established economies in Germany, France, and Great Britain, returns exceeding 25% weren't rare in 2006.

Looking at the best-performing closed-end funds for 2006, it wasn't any great surprise to see the Greater China Fund (NYSE:GCH), given the predilection investors have for anything related to one of the fastest-growing markets in the world. However, another fund on the list was a bit of a shock: the Herzfeld Caribbean Basin Fund (NASDAQ:CUBA). A closer look at the fund reveals some aspects of investing in closed-end funds that you should understand fully before buying any fund.

Betting on capitalism
What makes the Herzfeld fund such a remarkable story is how it appeared in the top ranks of funds apparently out of nowhere. From its inception in 1993, the fund's shares have traded in a relatively narrow range, rising as high as $8 and falling as low as $3 as recently as 2003. In just the past three months, however, the stock not only broke out of its trading range but quickly doubled in price, and it has traded as high as $18 before falling back to its current levels around $17.

It's clear from the timing of the fund's successes that many investors are buying shares on speculation that economic and political change in the Caribbean, and especially Cuba, will bring big profits to the companies that the fund owns. The fund's shares jumped significantly on news of Fidel Castro's illness in July, and continuing uncertainty about the leader's health has sustained and added to its gains. The fund's stated objective is to choose companies most likely to benefit from continuing economic and political developments in the region.

Speculation vs. fund fundamentals
A closer look at the fund, however, reveals some warning signs that are often present in closed-end funds. Despite the fund's excellent market performance, it only has about $13.5 million in assets, which makes it particularly small even by closed-end standards. The low level of fund assets means that there are relatively few shares to bear the cost of the fund's expenses, and so the fund has a high expense ratio of 3.37%.

More troublesome is the performance of the fund's investments in relation to its market price. With traditional mutual funds, you can buy or sell shares daily at prices that are based on the value of the fund's net assets. With closed-end funds, however, there isn't necessarily any correlation between how the companies that make up the fund's investment portfolio perform and how the fund's share price behaves.

Nowhere is this more evident than with the Herzfeld fund. According to information found on the Closed-End Fund Association website, while the market value of the fund's shares have risen by nearly 135% in the past year, the net asset value of the fund's investment portfolio has only gone up by about 12.5%. You can also see how the recent run-up has affected the averages over longer periods, with the shares rising at more than twice the rate of the fund's investments over the last decade.

The most telling sign of exuberance in the Herzfeld fund is the premium of market price to net asset value, which currently stands at an outrageous 102%. This means that for every dollar of value within the fund's investment portfolio, the shares will cost you more than $2 to purchase. Although high premiums have been known to persist for months or even years, in the long run, it's likely that those who are buying shares now will eventually suffer losses when the premium falls. Shareholders of the Greater China Fund have seen that for themselves, as a premium of about 25% has evaporated, leaving shareholders with a loss of nearly 20% in just the past three weeks.

Do it yourself
If you like the ideas behind Herzfeld's investing but aren't thrilled about the high costs and potential for losses, you can look behind the fund's surface and buy the same stocks that the fund has bought. Among the largest holdings within Herzfeld's fund are Florida East Coast Industries (NYSE:FLA), Watsco (NYSE:WSO), and Royal Caribbean (NYSE:RCL). Instead of paying premium prices for shares of the fund, purchasing shares of these companies directly can either save you money or allow you to buy the equivalent of twice as many shares.

Investing in closed-end funds can be both informative and profitable, but you have to be aware of some of the unusual characteristics that distinguish closed-ends from other investment vehicles. As with traditional mutual funds, low levels of assets can make a fund extremely expensive for investors. Moreover, while there are plenty of funds that trade at discounts to their net asset values, the most popular ones are often the ones trading at the highest premiums, posing additional risk. While the Caribbean Basin Fund did well for shareholders in 2006, anyone looking to chase that performance with a new investment should be wary.

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Fool contributor Dan Caplinger won't be waiting in line for cigars when the Cuban embargo ends. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy works around the world.