One area that I’ve always thought was under-represented was closed-end funds (CEFs). Most people know mutual funds and invest in them, primarily because they can buy mutual funds without incurring commissions (a pretty good reason when you’re investing with every paycheck).

CEFs differ from mutual funds primarily in that they don’t accept new money after they are created. When you buy a mutual fund, the fund manager gets your funds and invests them for you. When you sell your mutual fund, the fund manager either has to sell something, or draw down the amount of cash the fund is holding. Tihs is one way that a CEF is better — when you buy or sell a CEF, you’re buying it in the open market and the fund manager does not have to raise cash.

CEFs have advantages in some markets because they allow the fund manager to take illiquid positions without fear of having to raise cash. This can be very beneficial with international investing strategies or bond funds.

Each fund trades independently from the net-asset value (NAV), so you can buy a fund at a discount to NAV or at a premium to NAV. It’s comparable to buying $1.20 for only $1. One of the most appealing parts of investing with CEFs is that you can buy the shares at a discount to the net asset value.

The premium and discount varries significantly with investor moods. We recently saw very high premiums in CEF, a closed-end fund that invests in gold and silver bullion (physical metal in a warehouse). The premium quickly dropped when the GLD and SLV ETFs were introduced, giving retail investors an alternative to the CEF fund.

On the flip side, you can look at a fund like GF, the New Germany Fund. It has consistently traded at a discount over the last few years, and because of it is a viable alternative to the EWG iShares ETF on Germany. (They’re not comparable — GF focuses on small-caps in Germany.) When you’re ready to sell, the discount will hopefully have shrunk, if not you pass the discount on to someone else.

This is particularly nice with bond funds where you can earn a higher yield by using CEFs. If you invest in an international bond fund like FAX, you can get the bond portfolio at a 5% discount to the current market value of the bonds. Add in the fact that the CEFs will often take on a small amount of leverage (with a professional money manager to manage the leverage) and you can find yields that are significantly higher than mutual bond funds.

Why would funds trade at a discount if everyone knows what the discount is? Sometimes the underlying NAV falls faster than the prices of the CEF can keep up with. More typically, investor emotions drive the CEF price up/down — pushing up to a premium when an investment class is “hot” and dropping to a discount when it’s ignored or out of favor. Fees are also a factor for the discount… fees come out of funds without additional incoming contributions, thus you should earn an extra return since you know the principal will be partially consumed by fees.

You can read more about CEFs or search for them at the Closed-End Fund Association‘s website. Likewise, you can research them at ETF Connect.