Mutual funds have become a dominant force in the global investment landscape. As of the end of 2007, more than $12 trillion was invested in U.S. mutual funds, nearly double the total assets of U.S. funds in 2002. And mutual funds aren't just a U.S. phenomenon -- a total of $26.2 trillion is invested in mutual funds globally.

But while mutual funds are enormously popular, there's another lesser-known type of fund that's been around even longer -- closed-end funds. Closed-end funds have been in existence since at least mid-19th century Britain. But with only $315 billion in assets in the U.S., this phantom fund class is only about 2.5% the size of the mutual fund industry.

Both mutual and closed-end funds offer some advantages for investors. Chief among those is diversification -- both mutual and closed-end funds represent ownership in a broad portfolio of stocks. Diversification can lower an investor's overall risk and enhance return prospects. But there are also some key differences between the two -- and one in particular -- that can make closed-end funds a more compelling choice for investors.

Closed-end funds are listed on one of the major exchanges. You can buy shares in a closed-end fund directly from your broker and can generally expect to pay the same commissions you'd pay to buy a normal stock. There are no up-front sales fees or fees for early redemptions, like you might expect from a mutual fund. Better still, closed-end funds trade throughout the normal trading day, so you can buy and sell shares in a closed-end fund at any time you wish.

And, of course, there are no minimums. You can buy closed-end fund shares in any amount you desire. Many are highly liquid and trade hundreds of thousands of shares every day.

But there is one major, lesser-known feature of closed-end funds that all investors should be aware of. This feature, if fully understood, can offer an advantage to investors, or it can be detrimental. Specifically, I'm speaking of the concept of premiums and discounts.

Because a closed-end fund trades throughout the day just like a stock, its price is determined by market demand, not by the value of the investments it holds. This means a closed-end fund could trade above the actual value of its holdings, or at a premium. It also means that it can be priced below the value of its holdings, or at a discount. Although it might seem as though closed-end funds should trade at or near the value of its holdings at all times, in practice this is definitely not the case.

The recent market environment is a perfect example. In the October panic-driven sell-off, investors sold-off closed-end funds en masse to raise cash with little regard for underlying values. As a result, the discount on many funds exploded to two or more times their normal levels.

Over the long term, however, closed-end shares do tend to revert to their intrinsic value. In some cases, management companies will even try to speed up that adjustment by actually buying back their own shares if they're trading at a discount. Meanwhile, some hedge fund managers have been known to actively short-sell closed-end funds that are trading at big premiums.

It's a good idea to try to buy funds that are trading either at discounts to their NAVs or at levels very close to this. If you can buy a fund at a discount, then you're essentially buying that fund's assets -- the stocks and bonds held by the fund -- at a bargain price. In this case, you stand to profit if and when that discount window is ultimately closed. As a general rule of thumb, funds that are trading at premiums of +3% or more should be avoided.

Important Note: In the remainder of this article, Market Advisor editor Paul Tracy provides the names of five of the best closed-end funds trading at a significant discount. And even better, he provides in-depth profiles of two of his favorites -- one that invests in major companies in an emerging-market country, and another that focuses on telecom companies in emerging markets. However, in order to view the remainder of this article, you'll need to subscribe to our premium investing newsletter -- Market Advisor. After you subscribe, you'll receive immediate access to this full article, as well as our monthly Market Advisor newsletter and a host of additional premium content. Please visit one of the following links to continue.

-- Paul Tracy
Editor
StreetAuthority Market Advisor

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