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Steep Cost Can Erase a Fund's Success

NEW YORK ( TheStreet) -- Bill Gross is famous for managing PIMCO Total Return (PTTAX) , the largest bond fund. But his top performer has been PIMCO High Income (PHK - Get Report), a little-known closed-end fund.

During the past five years, the high-income fund has returned 16.8% annually, outdoing nearly all the fixed-income funds tracked by Morningstar. The PIMCO portfolio pays an eye-popping distribution of 11.4%.

Should you rush out to buy the star PIMCO fund? Probably not. The problem is that the fund sells at a steep premium. Like other closed-end funds, PIMCO High Income trades on exchanges like stocks. When investors are enthusiastic about a closed-end fund, they can bid the share price above the value of the assets in the portfolio. That has happened to PIMCO High Income and the shares now trade at a 41% premium.

In other words, an investor must pay $1.41 to buy a dollar of assets. "It makes no sense to pay such a huge premium," says Mike Taggart, Morningstar's director of closed-end fund research.

Taggart cautions that premiums often melt away as share prices dip. During the past three years, PIMCO's premium has been as high as 86%. At other times, the premium disappeared entirely. In the darkest time of the financial crisis, the fund dropped to a discount of 29%.

PIMCO High Income is not the only fund to sell at a big premium these days. According to Morningstar, there are currently 19 funds that sell for premiums of more than 10%. The most expensive fund is Cornerstone Total Return (CRF), which has a premium of 52%. Other high-premium funds include BlackRock VA Municipal Bond (BHV), with a premium of 23.9%, and Pioneer High Income (PHT) , with a premium of 13.6%.

Instead of buying funds that sell at steep premiums, most investors should focus on portfolios that sell at discounts. To own a fund that sells at a small discount, consider Invesco High Yield (MSY). During the past five years, the fund returned 12.2% annually and outdid 79% of its peers. Invesco pays a distribution of 8.7%.

Another fund that sells at a discount is Nuveen Municipal Income (NMI) , which returned 5.3% annually during the past five years and outdid 84% of competitors. The fund pays a distribution of 5.5%.

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