The Right Place to Look for Great Value

The key to successful value investing is to find investments that are priced below their intrinsic value. Yet while many experts claim to pick stocks based on value, one pair of money managers can show how the investments they select for their clients actually do cost less than they're truly worth.

With hundreds of value-based mutual funds available to investors, it's rare to run across one with a truly novel approach to value investing. But the RiverNorth Core Opportunity Fund, managed by Patrick Galley and Stephen O'Neill, stands out from the crowd thanks to its willingness to invest in securities that few others feel comfortable buying.

The secret to value success
The RiverNorth fund uses what's known as a tactical asset allocation model, which means that rather than dividing up the fund's money by fixed percentages into particular types of stocks and bonds, the portfolio managers have discretion to shift more money into investments they believe have better potential. The fund gives the managers discretion to invest 40%-80% in equities and 20%-60% in fixed income products.

The unusual thing about the RiverNorth fund, though, is the investments it chooses to follow its asset allocation strategy. Rather than picking stocks, the fund managers search for closed-end funds that are trading at an irrational discount to their net asset value. If they can't find a bargain closed-end fund, then the managers invest in sector ETFs to minimize costs. But that doesn't happen very often; as of June 30, more than two-thirds of the portfolio was invested in closed-end funds.

What the fund owns
A look at the RiverNorth fund's recent portfolio gives you some ideas of the bargains they're finding. Here's a short list:

Source: Morningstar.

Through its closed-end fund investments, the RiverNorth fund has an interest in some great stocks. More importantly, it tends to pick those shares up for between $0.80 and $0.95 per dollar of value.

The fund has only been around for less than three years, so it's too early to draw any firm conclusions about its performance. So far, though, the results look fairly promising. Over the past year, the fund is up 9% versus a down performance for the S&P, and it has risen over 38% so far in 2009. And while the fund suffered a substantial loss of nearly 28% last year, it still managed to outperform both its category average and the S&P.

Paying the price
What makes that performance all the more extraordinary is that it comes despite some big headwinds in the form of costs. The RiverNorth fund comes with a hefty expense ratio of 2.45%. That's largely because of the fund's multiple layers of costs. Not only must investors pay RiverNorth's own management fee, but they also bear the expenses of the underlying closed-end funds and ETFs that RiverNorth invests in. With many closed-end funds charging 1% or more by themselves, those combined expenses add up in a hurry.

Ideally, though, the fund can make money in two different ways. If the discounts on its closed-end fund investments narrow, then the RiverNorth fund benefits even if the prices of the underlying assets stay the same. Moreover, if RiverNorth's choices of sectors are good, then those underlying assets should also rise in value, potentially giving shareholders a double boost.

Given the high costs and limited track record, I can't recommend the RiverNorth fund without reservation. Yet the novel strategy that the fund follows can give you hints on how to create your own value-based portfolio of closed-end funds. By seeking out funds that both trade at discounts and hold the sort of stocks you'd want to own anyway, you can pick up great bargains that could improve your returns for years to come.