Hedge funds – how to diversify your portfolio

Close-up on a trader watching the stock market behavior on his laptop

(Image credit: Hispanolistic)

published 13 May 2024

Retail investors often overlook hedge funds, as these vehicles are not aimed at them. Hedge fund managers are only allowed to market themselves to wealthy investors, with many demanding a minimum stake of at least £100,000.

Hedge funds are not like the investment funds available to the everyday investor. They are lightly regulated and can invest in a wide range of assets. The most common fund used to be the long/short equity fund.

Long/ short funds buy the stocks they like best, the ones they think are going to go up, while shorting the ones they think are going to lose value: a hedged equity strategy. In theory, this strategy will lead to lower losses when the market is falling, underpinning smoother, higher returns in the long term.

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Hedge funds: how to diversify your portfolio

Long/short funds still dominate the $4trn sector. Still, there are plenty of other strategies, such as algorithmic trading funds, debt-focused funds, macro funds (which trade assets such as bonds and commodities), commodity-focused funds, activist hedge funds and funds managed by short-sellers, who seek out the market’s disasters before they happen. But why would an investor want to own a hedge fund?

Put simply, hedge funds can provide diversification into various asset classes and provide exposure to different investment managers. Wealthy individuals may own stakes in several hedge funds alongside other investments to help them build exposure to trading strategies they may not understand or have the resources to trade.

Man Group (LSE: EMG) is the world’s largest publicly traded hedge-fund firm, and a good case study of how hedge funds operate. It specialises in trading foreign currencies using computer models and last year one of the best-performing investment strategies was a fund called Man AHL TargetRisk, which generated annual returns of 14.1% by trading assets such as credit-default swaps, futures contracts on stock indexes and government debt for France, Germany, the UK and the US.

Investors like this approach. The overall group’s assets under management surged by 17% last year to a record high of $167.5bn. Man Group takes annual management fees and performance fees if a certain performance hurdle is met on the funds. This is one of the easiest ways to profit from hedge funds without running the gauntlet of selecting one yourself. The stocks yield 5.7% and the company has been spending money to buy back stock.

Pershing Square Holdings (LSE: PSH) is an investment trust that follows the strategy of the Pershing Square hedge fund. It has earned one of the best returns of any investment trust thanks to its focused portfolio – another hallmark of hedge funds, as unlike open-ended retail funds they don’t need to conform to diversification rules. Over the past five years, Pershing Square’s hedge fund has returned 203.5%.

BH Macro (LSE: BHMG) is another investment-trust hedge fund. BH Macro tries to trade global financial markets, using instruments such as debt, foreign currencies, swaps and commodities to earn a positive annual return. Over the past decade the fund has returned 95.5%, providing profitable diversification to a portfolio. The trust’s sterling class is on a 12.2% discount to net asset value (NAV). If the discount stays wider than 8% over the year, shareholders are allowed a discontinuation vote in 2025. The board has bought back shares to try to close the discount.

Then there is Tetragon Financial Group (LSE: TFG). While technically not a hedge fund, the close-ended company invests like one. Its portfolio is a mix of private assets, bank loans, venture-capital equities and real estate. Since the firm listed in 2007, its NAV has risen by 426%, more than double the return of the MSCI All Country World index. The shares yield 4.6% and the fund has been buying back shares. The shares currently trade at a 69% discount to NAV.

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Rupert is the former deputy digital editor of MoneyWeek. He's an active investor and has always been fascinated by the world of business and investing. His style has been heavily influenced by US investors Warren Buffett and Philip Carret. He is always looking for high-quality growth opportunities trading at a reasonable price, preferring cash generative businesses with strong balance sheets over blue-sky growth stocks.

Rupert has written for many UK and international publications including the Motley Fool, Gurufocus and ValueWalk, aimed at a range of readers; from the first timers to experienced high-net-worth individuals. Rupert has also founded and managed several businesses, including the New York-based hedge fund newsletter, Hidden Value Stocks. He has written over 20 ebooks and appeared as an expert commentator on the BBC World Service.