Rising fears of an AI bubble are plaguing the market and some investors could be at risk of seeing a significant hit to their holdings if a bubble does burst. 

Many investors, though, are putting themselves in risk positions from the outset.

In this column, William Heathcoat Amory, managing partner at Kepler Partners explains the benefits of a properly diversified portfolio.

Many commentors are cautioning about a potential stock market crash, and the noise seems to have intensified in recent weeks. 

Then again, a stopped clock tells the right time twice a day.

However, with the AI frenzy leading a select group of stocks ever higher, the bankruptcy of First Brands Group causing worry in private credit markets, and the gold price going parabolic, there are many conflicting signs that indicate all may not be well for financial assets. 

One can't help but cast around for signs of a rescue boat.

Diversification is key

Diversification is the only free lunch in investing. But where honestly can one turn? 

Bonds tend to have an inverse correlation with equities and offer decent yields. However, with inflation an ever-present threat (or reality), they may prove a rather leaky lifeboat.

What investors need is some form of portfolio insurance. But the perennial problem with buying insurance is that the insurance companies always win. 

The longer you insure something, the more likely you are to end up paying for your losses in the end. This is the case with investment options like structured products and tail protection strategies. 

Unless you get the timing perfect, the costs of insurance tend to outweigh the long-term benefits. 

Certainly, it may allow you to sleep better at night, but this is what you are buying from insurance companies and tail protection strategies alike, and how they profit.

So, insuring your portfolio isn't necessarily the best option. A less costly alternative is a fund that has the potential to act as an insurance policy, but one that isn't guaranteed. 

This may seem like a misstatement, but actually what we are saying is that we want a fund that will pay for itself over time in delivering real returns, but has the potential to offset equity losses in a portfolio at times of peak stress. 

Potential means it is not guaranteed – sometimes it will, sometimes it won't.

Uncorrelated returns via flexible investment trusts

One such option could be Ruffer Investment Company (RICA). RICA aims to deliver consistent positive returns, regardless of how financial markets perform, while protecting against market falls. 

The fund has had a tough time in performance terms over the last couple of years. Unequivocally, market conditions have not suited the strategy. 

Historically the strategy has performed strongly when equity markets have struggled. Indeed, the best period for performance was during the equity crash in 2008.

In today's climate, the managers are anticipating what appears to be regime change in global markets, and an emerging world in which the dollar could follow equities and bonds down in a crisis, and fail to provide diversification when equities are weak. 

RICA's unconventional strategies and sophisticated use of fixed income instruments and derivatives look appealing in this new environment. 

Another key risk the portfolio is positioned for is a new wave of inflation, which recent data suggests may be building, and makes generating real returns even harder.

Another potential option is Majedie Investments (MAJE), which has been run by Marylebone Partners since 2023. Majedie Investments (MAJE) aims to deliver annualised returns of at least 4 per cent above the UK Consumer Price Index (CPI) over rolling five-year periods, employing a 'liquid endowment strategy'. 

The 'endowment' element refers to a fundamental, long-term approach to investing, focusing on differentiated sources of return with high potential, while the 'liquid' aspect reflects the avoidance of unlisted, hard-to-price assets.

MAJE's strategy is highly differentiated and focuses on under-the-radar and often unique sources of return. 

This approach may provide valuable diversification at a time of heightened concentration and elevated valuations in equity markets, as well as tight spreads in credit markets. 

Moreover, MAJE offers access to carefully selected specialist managers that are otherwise difficult to access, along with exclusive opportunities through its special investments.

MAJE currently trades at a discount of c.17 per cent, after having commanded a premium or traded very close to par between mid-April and the end of May, when investors were seeking opportunities outside the US. 

Interestingly, the widening of MAJE's discount since then has coincided with the strong rebound of AI-related stocks. 

We view Marylebone Partners' agreement to join Brown Advisory as a very positive development, as it will give the team access to significantly deeper resources, but will see no significant change to the way they manage MAJE's assets.

The diversifying power of hedge funds

Our final suggestion to boost diversification in portfolios is macro hedge funds, which have long been known to exhibit some characteristics of portfolio insurance: they tend to perform strongly at times of high market volatility and have tended to have low structural correlation with equities and bonds. 

The problem for retail investors is that macro hedge funds are typically hard to access and are not typically available on investment platforms. 

They are rightly the preserve of more sophisticated investors, given the underlying investment strategies are relatively complex and hard to understand. 

That said, hedge funds tend to look at risk in terms of absolute losses, rather than many equity funds which see risk in terms of underperformance of a benchmark. 

In this way, hedge funds might actually seem more aligned with retail investors who have an aversion to absolute losses. 

There are not many investors who take much comfort from an equity manager that they outperformed a benchmark loss of 30 per cent by 1 per cent!

BH Macro is one such option for investors seeking portfolio diversification qualities. It is a listed fund which invests directly into the Brevan Howard Master Fund, the long-standing flagship macro hedge fund of Brevan Howard (BH). 

According to LCH Investments, BH is in the top twenty hedge fund managers of all time in terms of profits generated for investors.

BH's traders take a very different approach to investing capital when compared to traditional managers of equity and bond funds. Their process doesn't rely on correctly anticipating the future path of equity or bond markets. 

Instead, traders tend to evaluate outcomes – say, on the future path of interest rates – and then compare them with what the market is currently pricing in. 

Where the potential for a move is perceived by BH traders as under- or over-priced by the market, BH's traders and risk team will seek to construct trades which have an attractive payoff if they are right, but minimise losses if they are not. 

BH describe this characteristic of trades, and of the Master Fund portfolio as a whole, as having convexity.

A parallel could be the way bookmakers' approach the Grand National. 

Bookies are not a charity for horseracing fans – they aim to make a hefty profit! Unlike a punter, the bookmaker is not trying to pick the winner in any race. 

Instead, a bookie aims to ensure that in every race they don't lose money, and ideally make at least some money whatever happens in the race.

The way bookmakers do this is to set odds across the field, which they adjust over time to encourage punters to bet on a wide range of horses, so that they manage their risks and ensure they end up with a profit at the end. 

They make the least money when the favourite romps home, and the 'market' was 'right'. 

But if the market is pricing the future incorrectly and an outsider wins, the bookmaker can potentially make very significant profits. 

The most successful book makers are therefore the best at risk management, rather than the best predictors of winners.

Brevan Howard are not bookmakers, but they are expert risk managers. The key is that for them to make money, it doesn't necessarily rely on traders' or economists' views of the future being correct. 

Instead, they look to manage risks very carefully, and hope to profit from unexpected events happening that are not priced into markets. 

It is this characteristic that has enabled BH Macro to deliver such attractive returns in past equity crashes.

The below chart shows BH Macro's GBP NAV performance in the twenty worst months for global equities since 2008, illustrating that in most cases, BH has significantly outperformed the index. 

For example in March 2020, as Covid wreaked havoc on global markets, BH Macro delivered a share price return of 14 per cent and a NAV return of 18 per cent (net of fees), compared to the S&P 500 loss of 12.5 per cent.

No investment team are infallible, and so this must come with the usual risk warnings that past performance is no guarantee of the future. 

However, the investment instruments and risk management strategies of investment trusts like Ruffer Investment Company, Majedie and BH Macro provide something very different to equities, offering crucial diversification, particularly in times of market stress. 

As cracks continue to appear in an already volatile macroeconomic environment, investors would do well to consider how best to shore up their portfolios against any future storms. 

An allocation to diversifying strategies like these could well prove a much-needed lifeboat.