Montreal, Canada

As a rule, closed-end fund investors should never pay a premium above net asset value. Your margin of safety always lies in purchasing a closed-end fund below its net asset value and, over time, benefiting from the narrowing of the discount.

As gold and silver continue to hit new highs this month (silver at a 30-year high), some investors are chasing a closed-end fund trading at a 7.8% premium above its net asset value (NAV).

The Central Fund of Canada (NYSE-CEF), a closed-end fund traded in the United States and Canada, continues to fetch a premium above its NAV. Throughout this bull market, investors have chosen to pay above and beyond the spot prices for this fund. Recently, CEF closed at a 13% premium above its NAV.

Why would someone pay a 13% premium to buy a fund employing a passive investment strategy holding physical gold and silver bullion?

Competitors like GLD, the SPDR Gold Trust, is an exchange-traded-fund holding physical gold. Like CEF, it provides an exchange-traded vehicle to participate in gold ownership combined with liquidity. But, unlike CEF, GLD owns only gold and no silver.

Still, a prospective bull on gold and silver is paying almost 8% above spot prices to own a publicly-traded fund holding gold and silver.

Since last year, CEF has been active issuing new shares as investor interest grows. In May, CEF closed a sale of 25.3 million units at $14.85 per share and raised $375.7 million dollars. CEF also has a pricing rule: It must be non-dilutive and accretive for existing shareholders. That’s a plus for existing investors; but over the past 12 months CEF has gained 22% compared to 26% for GLD and 24% for SLV or the iShares Silver Trust.

The only viable reason someone would buy a fund like CEF is because they don’t want to own gold and silver directly – an option that would save the buyer about 3% on dealing charges, which is the difference between the spot price and the spread. From its premium recently of 13%, that savings would rise to a not so insignificant 10%.

Is CEF worth such a high premium?

I think the real reason why investors are lunging after CEF – despite the premium to NAV – is because they don’t trust ETFs like GLD or SLV.

Conspiracy theories abound about how ETFs don’t hold sufficient bullion; personally, I believe they do. I find it difficult to imagine that gold-bugs like John Paulson, the hedge fund guru, are invested in a potential GLD-ponzi scheme. Soros is another big investor in GLD.

There’s no compelling reason to pay such a high spread to gold and silver. In addition to ETFs, which mostly trade at NAV, investors wary of GLD’s or SLV’s physical holdings can opt to purchase gold and silver coins and save about 3% or 4% after discounting for CEF’s current premium.

Investors tend to be irrational sometimes. Other closed-end funds trading at ridiculous premiums include PIMCO’s High Income Fund (NYSE-PHK), which fetches a mind-boggling 52% premium above NAV. Another stupid premium is what investors pay to own the John Hancock Investors Fund (NYSE-JHI), which invests in domestic taxable bonds. That premium is 13.2% above NAV.

My rule stands unchanged: Always buy a closed-end fund trading at a discount. Over time, it’s your highest margin of safety in any market.