Don't Pay Premium Prices for These Stocks

If you're looking to get into the stock market, you'll have to pay a heftier price for most companies' shares than you would have earlier this year. Yet even though buying stocks can be the smart move even at these higher prices, there's one investing method where it really makes no sense to pay up.

Many closed-end funds have been trading at massive premiums for a long time now. It's true that simple momentum, along with supply and demand factors, can keep closed-end funds at lofty levels for a while. Eventually, though, they'll have to break, and shareholders will be left holding the bag.

Why pay more?
Closed-end funds have been around a lot longer than the now-ubiquitous exchange-traded funds, but they still command an important niche in the investment world. Unlike ETFs and mutual funds, closed-ends keep the amount of outstanding shares constant; shareholders can't go to the fund company to buy new shares or to redeem the ones they own. As a result, the only recourse investors have if they want to trade in a closed-end fund is to buy or sell shares on the open market.

Because shareholders are never guaranteed that they'll be able to get paid their proportional share of the fund's assets, closed-end fund shares often trade at prices that bear little relation to their actual intrinsic value. Funds publish their net asset value (NAV) per share on a regular basis, so investors can see just how the prices differ in the open market.

The relative illiquidity of closed-end fund shares causes many funds to trade at a discount to their net asset values. But occasionally, you'll run into some situations in which investors bid up shares above NAV. Here are just a few of the funds trading at premium prices recently:

Source: Morningstar, Closed-End Fund Association. Returns are based on market price, not NAV. As of Aug. 4.

The higher they go, the harder they fall
At first, closed-end funds trading at premiums may look extremely attractive. After all, they've typically put in some impressive performance in the recent past, making it appear that whatever investing strategy a particular fund is using has worked well and may continue to do so in the future.

Yet in nearly all cases, those premiums oscillate wildly over time. If you pay a 50% premium to net asset value one day, you might find that sometime in the future, that premium has disappeared entirely. That can spell disaster. Even if the fund's NAV hasn't budged, you'd still have a 33% loss on your shares without the premium. And if the market has risen in the interim, pushing NAV up 50%, you could still be left without any gain at all on your shares once the premium disappears.

What to do
If you think a closed-end fund that's trading at a premium has good investment ideas, then the best thing to do is to go out and buy the companies it holds yourself. All of the funds above own investments that you can buy and sell directly on the stock exchange. For instance, if you think master limited partnerships are a good buy right now, you can just buy shares of Kinder Morgan Energy Partners and other holdings of the Cushing fund yourself.

Closed-end funds aren't always easy to understand, and in a world that has gotten used to the idea that ETFs trade near their actual intrinsic values, it's easy to forget that closed-ends don't play by the same rules. In many cases, closed-end funds can be good choices for smart investors. For the most part, though, it doesn't make sense to pay premium prices for them.

For more on smart fund investments, read about:

• What wealthy investors are doing now.
• Recovery is right around the corner.
• Should you be an instant IPO investor?

Start investing today -- just $7 per trade with Scottrade. Or find the broker that's right for you.