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), 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%.

Some closed-end funds have been driven to premiums by investors who are scrambling to obtain extra yield. At a time when yields are puny on most bonds and bond funds, closed-end funds represent one of the few vehicles paying double-digit distributions. The rich yields are possible because of the rules governing closed-end funds.

While typical mutual funds cannot use leverage, closed-end funds are permitted to boost their yields by borrowing or using other techniques. Say a closed-end bond fund has $100 million in assets. The portfolio manager can leverage by selling $20 million in preferred stock. Now the fund has a leverage ratio of 20%. The manager can take the cash raised from the stock sale and use it to buy more bonds. That increases the amount of income that can be distributed to shareholders.

In good times, leverage magnifies the returns that shareholders receive. But in downturns, leverage can increase losses. That has happened to PIMCO High Income, which has a leverage ratio of 26.6%. In the downturn of 2008, leverage pulled down the fund, which lost 45.3% for the year and trailed 75% of peers. During the rebound in 2009, PIMCO returned 155.3% and outpaced 99% of competitors.

Leverage can boost the yields of closed-end funds and make them appealing choices for investors seeking income. But if you buy a closed-end primarily for yield, pay close attention to the fund's history of paying distributions.

Some funds deliver steady income, while others produce more erratic results. In recent years, Invesco High Yield has produced relatively steady income. In contrast, Cornerstone Total Return has an erratic record and failed to deliver income in some years.

In order to pay for the regular distributions that shareholders expect, Cornerstone has been pulling assets out of the portfolio. This is known as a return of capital. Morningstar's Taggart warns investors to beware of companies that are boosting distributions by returning capital. The process can diminish the assets in a fund and result in weak long-term returns.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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