With a market run-up, it could pay for clients to consider the handful of closed-end stock funds selling at bargain-basement prices.

The average closed-end stock fund's market price trades at a 10% discount to its net asset value. But the average closed-end fund's net asset value, thanks to the stock market's rise so far this year, was up 12% as of mid-February, according to Thomas J. Herzfeld Advisors Inc., Miami. "With equity prices showing strength of late, now is a good time to invest," suggests the firm's chief investment officer, Cecilia Gondor.   

Closed-end mutual funds issue a fixed number of shares that trade on a stock exchange. But unlike traditional mutual funds, which are traded at net asset value, a closed-end fund's share price fluctuates, based on market supply and demand. As a result, closed-end funds can trade at discounts or premiums to their net asset values.
Research over the past two decades has consistently shown that it can be profitable to invest in a closed-end fund selling at a discount when the discount to the fund's net asset value narrows at least 3 percentage points. Portfolios using this tactic have outperformed the S&P 500 over the long term.

But this may require a long-term trading strategy. Over the short term, owning closed-end funds at a discount can prove risky. Closed-end fund stock market prices are 64% more volatile than their net asset values, according to a study by Jeffrey Pontiff, a Boston University finance professor, published in The American Economic Review, Pittsburgh, in 1997.

Although that study is more than a decade old, the more recent market downturn of 2008 seemed to substantiate Pontiff's assertion that closed-end stock prices are more volatile than their net asset values. That year, the average closed-end fund stock price lost 39% compared with a 37% loss on the S&P 500, according to Morningstar Inc., Chicago.

Gondor says advisors must be selective when buying closed-end stock funds. Only a few have appealing discounts. These funds often are overlooked because of low yields. Most of the money has been pouring into closed-end bond funds that pay high yields because the portfolios are leveraged. Bond closed-end funds, however, are overvalued and poised to decline when interest rates rise, she warns.

Stock funds with little or no distributions, including those that make only annual payouts of net realized capital gains, continue to trade at the widest discount levels of all categories, she adds.

"There are signs that this disparity in valuations between equity funds and income funds may be starting to change," she says. "Over the past year, we documented more distribution increases than decreases among equity and specialized equity funds while recent trends show equities, in general, are returning to favor."

Meanwhile, Gondor says taxable closed-end bond funds are slashing distributions. Tax-free municipal bond funds may cut payouts in the future because the funds are paying out more to shareholders than they are earning in interest and capital gains.

"We sold municipal [closed-end] funds last year and lightened our holdings in other income-oriented funds over the past month," she says. The objective: to sell into the "January effect"-a seasonal narrowing of discounts after a period of widening created by year-end tax-selling pressures.

The few closed-end funds she favors include large company stock funds, such as Adams Express, General American Investors and Central Securities Corp. On the small stock side, Royce Micro-Cap Trust, she indicates, may be a good buy. If the stock market continues to perform well, the discounts on these funds could narrow to 8% or 9% from 15%, she believes.

Maury Fertig, chief investment officer of Relative Value Partners, a Northbrook, Ill., investment advisory firm, stays fully invested in a combination of closed-end and exchange-traded funds he expects to rebound from being historically undervalued. He favors closed-end funds because they are not widely followed by Wall Street analysts. There are few institutional investors in this market. Plus, the funds can use leverage at a lower cost than brokers offer retail clients. Leverage can boost yields and total return on the upside.

Like others, he's not buying closed-end bond funds because they are trading at a premium. At the end of last year, he profited from two Sun America closed-end funds that converted to open-end mutual funds. Those funds were SunAmerica Focused Alpha Growth Fund Inc. and SunAmerica Focused Alpha Large-Cap Fund Inc. When a closed-end fund converts to an open-end fund, investors get the net asset value of the fund.

This year, he bought the Nuveen Multi-Strategy Income Growth fund. The fund, now selling at a 15% discount to net asset value-compared with similar funds' 9% discount, is changing its investment objective to a bank loan fund from a stock and bond fund. Fertig expects the change will narrow the Nuveen fund's discount. The fund pays a distribution rate-comprising interest, income and accumulated capital gains-of 8%.

Fertig also favors the Eaton Vance Tax-Advantaged Dividend Income Fund, which is trading at a 13% discount to net asset value. The fund writes covered call options on its stock portfolio. In 2010, the fund cut its dividend and retail investors fled. He expects the stock price to rebound if the overall stock market performs well. The fund has a distribution rate of 11.9% annually because of dividend and call option income. Although that figure may also include some return of capital, the fund can write down the tax basis of its holdings as call options expire.

He expects the Royce Value Trust, which sells at an 8% discount, to perform well. That fund has been selling at a discount for almost two years because the company stopped paying dividends following the 2008 market meltdown. The fund's distribution yield in mid-February was 6%.

Fertig adds that well-managed diversified closed-end stock funds can optimize well in a portfolio of securities. So a large-cap fund, like Tri-Continental, which is selling at a discount, is as good a long-term investment as an open-end stock fund.

Before you commit to a closed-end fund, Mike Taggart, director of closed-end fund research at Morningstar, says you should analyze a fund's market price discount history. Some funds trade at a discount for an exceptionally long time and show little upside momentum.

Taggart recommends looking at Morningstar's "z" statistic on its Web site to determine if a fund's market share price should rebound. The statistic considers the current discount of a fund compared with its discount in the past, taking into account the volatility of the fund's share price. Funds that score below -2 on the "z" statistic are considered cheap and could rebound, narrowing the discount to the net asset value.

Currently, Morningstar's list of attractive top-rated closed-end funds to be evaluated include: H&Q Life Sciences Investors, which trades for 90 cents on the dollar, but the share price of the fund was up 15% in 2012 through mid-February. On the international side, the Templeton Dragon Fund sells at 90 cents on the dollar and was up 11% over the same period.

The majority of taxable and tax-free bond funds are selling at premiums to net asset value as investors pile in to capture higher yields. Nevertheless, the PIMCO Income Opportunity Fund is selling at 90 cents on the dollar.

Taggart recommends that advisors take other variables into consideration besides the discounted stock prices. "Once you purchase a closed-end fund, the only thing you should care about is the subsequent total return," he says. "If you buy a closed-end fund at $8 per share when the fund is trading at a 5% discount, you're likely to be satisfied when the fund is trading at $9 per share, even if the discount has widened to 10%."

Financial advisors scrutinizing closed-end funds can spot investment opportunities in funds that may exhibit some of the following characteristics, based on research studies published by the National Bureau of Economic Research, Washington, D.C. For example:
A fund that owns restricted stocks or has unrealized capital gains in the portfolio can sell at a discount.
If you get wind of a portfolio manager's pay raise, consider that the fund's discount often narrows when compensation increases.
Funds that don't disclose the portfolio holdings as frequently as other funds tend to have larger discounts.
Funds that use leverage typically sell at larger discounts when their respective markets are underperforming.
Closed-end country fund share prices are often a function of countries' overall weightings in foreign stock market indexes. So the discount can swing with bull and bear markets. As a result, bear markets may lead to big discounts in closed-end country funds.
Poorly performing funds with large discounts tend to bounce back when an exiting manager is replaced.
Discounts and premiums track the investment cycle. So when small company stocks perform well during the first stage of an economic recovery, it is an indication that other stock fund discounts may eventually narrow.