Want to start your own hedge fund?

Today I would like to show you how you can create your own hedge fund.

Don't worry it's not going to be complicated. You can kick it off with as little as £2,000. And there's no need to call on the services of City whizz-kids and their crazy fees.

Because the fact is that you can use investments available through your regular stockbroker to increase returns the hedge fund way. And I'll show you how it could help double your income on stock market investments.

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It starts with a smart way to buy investment trusts

A shortcut to creating a hedge fund

I like investment trusts. They're pooled funds, offering diversification and tend to have lower fees than their mainstream unit trust peers.

For example, I could buy the Perpetual Income & Growth Investment Trust (LSE: PLI) for £2.71 through my regular broker. It's yielding nearly 4% and has won an award from The Investment Week Investment Trust of the Year Awards for Most Consistent Performer' overten years.

Fine. But let me show you what a hedge fund guy might do...

Because, as well as issuing shares, investment trusts often issue subscription shares (or warrants) too. These shares give you the option to convert them into fully fledged investment trust shares at a given price in thefuture.

In this case, Perpetual Income & Growth Investment Trust's subscription shares (LSE: PLIS) allow you to convert your subs' into investment trust shares at the end of August 2013.

What will you pay? Well, this morning the subs cost 45p and to convert them into the investment trust shares, it'll cost you £2.19 come next August. In all, you'll pay £2.64. And that's less than if you buy the investment trust shares in the market today.

Note that, with subs, you won't be entitled to any dividends until they're fully converted. At the moment the investment trust is paying out nearly 4% - so you would have to give that up.

But then, you'd only be shelling out 45p today. You don't have to pay the £2.19 until the end of next summer.

And that offers us two big benefits that a hedge fund manager might enjoy...

If the markets crash

First off, remember I said that these subs give us the option, but not the obligation of converting into full shares. If the investment trust goes up, we will get all the upside. Every penny the investment trust shares goes up, my subs should too.

BUT if the markets have a nasty time between now and the end of August 2013, and the investment trust ends up worth less than £2.19, then I don't have to pay to convert them into shares. The maximum I can lose on this side of the deal is 45p (that's how much I paid for the subs).

And believe me, this can be a fantastic benefit. A little while ago I sold my holdings in a European property trust, and bought the cheaper warrants instead (warrants work just like subs). Going by this morning's price, the property trust has lost over half its value. But I've only lost the value of the warrants and that's much, much less. The amount I gave up in dividends is insignificant I am very pleased to have cashed in most of my investment early and only held the warrants.

What to do with the money instead

The second benefit with the subs is that having only laid out a small amount of cash, I can reinvest the remainder somewhere else...

Instead of shelling out £2,000 on 730 shares (730 x £2.71 = £1,980), I'm going to buy 730 subs at 45p. That'll cost me £328.50 plus commission. Call it £350.

That leaves me £1,650 to play with.

Now in the recent past, I've shown you how you can achieve pretty reasonable returns with bonds. I've shown you Enterprise Inns 2018 with a yield of 11.5%. I've shown you a Royal & Sun Alliance bond with a 7.35% yield, and just recently I've shown you a Co-op Bank bond with a running yield of 8% (with the potential for even more).

Let's say I plump for the Enterprise Inns bond. Today it'll cost me about 82.5p to buy (plus some accrued interest but we can ignore that because I get it back when the bond pays its next coupon).

I can get 2,000 of these bonds for about £1,650.

Now let's see what we've got

Instead of buying 730 shares in the Perpetual Income and Growth Investment Trust for about £2,000, we've bought 730 subs. With them we've got all the upside if the trust goes up, but we've limited our downside to £350.

With the remainder of the cash we've bought 2,000 Enterprise Inns bonds. We've given up a 4% yield on our £2,000... that's about £80. But with the bonds, we're getting about 11.5% (on our £1,650 investment). That's about £189.75.

That's more than double the interest we would have received on the investment trust. And we're still fully exposed to any upside of the trust. AND to top it all, we've got downside protection if the stock market crashes.

Of course there are risks...

Having bought my Enterprise Inns bonds, I've now taken on the risk of Enterprise Inns. If you're considering these bonds, then I'd urge you to look at my original recommendation and all the risks attached. That said, I like the fact that these bonds are fully secured on property... why not take a look?

Bear in mind that when I say Enterprise is paying about 11.5%, this figure is approximate. Some of that value is likely to come as a capital gain on the bond. We could end up with more, or we could end up with less. There's no way of guaranteeing the price you'll get for a bond when it comes to selling it.

And also bear in mind, you can use whatever bonds (or any other investment for that matter) you like. If you want to put your money somewhere safer, that's up to you. You're the hedge fund manager now!

Subscription shares tend to be quite illiquid. You may have trouble buying and selling in size, and the price may change considerably. But the beauty of this is it keeps big fund managers away. There's no way they could trade in these sorts of stocks in a meaningful way.

I've shown you how to use a warrant to reduce your initial cash outlay on an investment trust. And then I've shown you how to use that cash to buy something else something with a more interesting yield. But in reality, I probably wouldn't match every transaction with an equal weighting in a bond. I'd just see the warrant as a part of my overall portfolio.

Now, on that basis, I hope you can see that it's quite easy for me to lose the whole of my investment on the subs. In this example, all it needs for me to lose my full £350 isfor the trust's price togo down from today's £2.71 to £2.19 (come next August). Always bear in mind that warrants and subs are highly leveraged products... you can quite easily lose the lot.

There are loads of warrants and subscription shares out there. This is but one example. But I'm a big fan of them. Because in my experience, you can use a sub to implement a hedge fund like strategy to increase returns without ratcheting up the risk.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

Important Information

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is an unregulated product published by Fleet Street Publications Ltd.

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