Buy a Buck for 87 Cents

I'm guessing that you've have never heard of Tri-Continental (NYSE:TY). Even though the publicly traded fund has been around since 1929, has paid out dividends for 62 consecutive years, and sports a reasonably low expense ratio of 0.66%, I'll concede that it's not exactly a household name.

That's because Tri-Continental is a closed-end fund. Despite watching over a sizeable $2.5 billion portfolio, it's one of the many closed-end funds that just aren't getting a whole lot of Wall Street loving despite trading for less than the market value of their holdings.

Yes, closed-end funds aren't bought and sold at Net Asset Value (NAV) like traditional mutual funds. That often creates disparities between the actual value of its net assets and the perceived value of a particular fund. Tri-Continental's NAV kicked off the week at $22.85, but I've got a neat little trick for picking up shares at just $19.87 a share. I call it "placing a buy order."

Giving it a Tri
Yes, Tri-Continental can be bought at a 13% discount to its NAV. That's 87 pennies on the dollar! You're not buying into chopped liver, either, since the fund buys into the bluest of blue chips.

To be frank, the fund hasn't exactly been a world-beater. Its annualized return over the past 10 years has fallen just short of 7%, off the S&P 500's 9% annualized return in that time. However, think about the prospect of buying this entire portfolio of stocks at a 13% discount. If you think that Inside Value pick Microsoft was a steal at $26.40 yesterday, imagine buying it at just $22.97. Like GE at its market price of $33.61? You'll just love owning a piece of it at $29.24.

Sure, it's not as easy as that. You can't just buy a share of Tri-Continental at a discount and sell its individual components at market value. You are buying marked-down stocks that are anchored to the market's perceived value of any particular closed-end fund. There are hundreds of closed-end stock funds, and practically all of them trade at either a premium or a discount to their underlying assets. The reasons for these diversions from the NAV have not yet been explained to the satisfaction of the academic community, and there are no guarantees that the funds will swing in and out of favor. Tri-Continental, for example, seems to always trade at a significant discount to its liquidation value. Over the past five years, the fund's discount has averaged 14%. To that end, Tri-Continental is doing its part to trim the disparity. It is looking to buy back as much as 5% of the outstanding shares this year, as long as the fund is trading at more than a 10% discount.

The open argument for closed-end funds
Two weeks ago, I spent some time talking to resident fund guru Shannon Zimmerman. He's amassed a spectacular record for Motley Fool Champion Funds subscribers. Of the 36 funds that he has singled out for the premium newsletter service, 28 have gone on to beat the market. None of them are closed-end funds.

It's not as if one can blame Shannon. There are thousands of conventional mutual funds that trade daily at their NAVs, and Shannon has a knack for nailing the upper echelon of actively managed open-end funds.

I asked him about closed-end funds anyway, because it has always been a fascinating -- and, in my opinion, sorely neglected -- subset of the investing world. Shannon voiced his concern that buying into closed-end funds can pose some pitfalls.

For starters, Shannon feels that it's a grave mistake to buy a brand-new closed-end fund. He's right. When a publicly traded fund has an IPO, it enters the marketplace at an overnight premium because the underwriting fees are deducted off the NAV. I can't argue with that. Paying more for a new offering than you have to is the equivalent of buying a traditional fund with a cruel load fee upfront. Shannon and I agree that fund buyers are better served by sticking to the no-load space.

Shannon also believes that there are plenty of closed-end funds trading at premiums when the more popular mutual fund universe is loaded with better alternatives that can be had at face value. Again, we agree.

Accepting that, I still think closed-end funds may be worth a smidgeon of space in your portfolio. I can boil it down to three reasons:

1. Discounts to NAV are everywhere, and if buying a new fund at a premium is a mistake, then buying an older fund at a discount appears to be the perfect counterargument in favor of buying in.

2. Because a closed-end fund has a fixed number of shares, managers are not distracted by the perpetual inflows and outflows of capital. That allows them to stick to their investing strategy without having to hoard away too much cash or sell stocks earlier than they would have liked in order to cope with the influx of new capital or the outflow of redemptions.

3. Closed-end funds have other distinct advantages. They never close to new investors or have to worry about bloated asset bases curtailing performance after a hot year. They don't have to introduce mean 12b-1 fees that find existing shareowners subsidizing the marketing costs of attracting potential investors. There isn't a hierarchy of fund classes that max out the alphabet. In short, a closed-end fund is simplicity in action.

Discounting the obvious
There are a few sources for tracking closed-end fund performances, but there should be more. You can look up the discount and premium discrepancies weekly in financial publications like Barron's, or you can turn to online sites like the Closed-End Fund Association.

Maybe one of these days I will talk Shannon into giving closed-end funds a little more lovin' in his market-crushing newsletter. I think I've got the "can't miss" argument, in that some of the fund families he's cherry-picked from in the past -- like Royce and Neuberger Berman -- have several closed-end funds on the market trading at discounts to their NAVs. Did you know that the Neuberger Berman Real Estate Securities (NYSE:NRO) fund can be had at a whopping 17% discount? Am I getting warm?

Then again, I would hate to get in the way of Shannon's great mutual fund picks. His average recommendation is trading 20.2% higher, and the respective indices are up just 9.9%.

In short, if Shannon were a closed-end fund, he would clearly be worth a premium. Then again, thanks to a 30-day trial subscription offer, you can read up on all of his mutual fund selections over the next few weeks for free.

That's a pretty good deal. I'll keep trying to lobby for more closed-end fund coverage around here. I think it's an investment class that has a lot to offer a diversified portfolio.

That's my two cents' worth. Or, given Tri-Continental's discount, make that my $0.0174 cents' worth.

Bank of America is a Motley Fool Income Investor recommendation.

Longtime Fool contributor Rick Munarriz has invested in closed-end funds in the past, though he does not own any at the moment. The Fool has a disclosure policy . He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.