Hedge funds could profit if battered financial stocks fall further

LONDON: The trade of the moment in the hedge fund industry - betting on falling financial stocks and rising commodities - is offering further profit despite a setback in July, but fund managers may have to alter their tactics.

Hedge funds could well benefit from betting that the bounce in battered financial stocks and the decline in commodities in July were only blips in a longer-term trend, since the fundamental reasons for selling bank stocks and holding commodities remained intact.

However, with investors nervously watching every piece of performance data, many funds have had to scale back the size of these bets to avoid more poor numbers. Or they are making bets likely to be less painful if markets go against them.

"I think the fundamentals still point to short financials and long resources," said Ken Kinsey-Quick, the manager of the Thames River fund of hedge funds. "Last month was a bit of an anomaly."

The average 2.61 percent loss experienced by hedge funds in July, according to the Credit Suisse/Tremont hedge fund index, was even worse than what they had reported in March. That was the month when the stock in financial companies rose in response to hopes that the bailout of the Wall Street investment bank Bear Stearns by the U.S. Federal Reserve meant that large banks would not be allowed to go bust.

Being short, or betting on a lower price in the future, on financial stocks hurt many hedge funds in March, with losses that averaged 2.11 percent.

The rally proved temporary, however, and after a disappointing month of returns for hedge funds, financial stocks resumed their downward spiral as write-downs continued.

In July the pain was felt by long-short equity funds, among the biggest players in this trade, which lost 3.43 percent. Managed futures funds, which follow trends in global futures markets but which are hurt by sudden market reversals, fell even more - an average of 4.2 percent.

Still, for those funds that have stuck to their financials/commodities bet, there are opportunities for further profit.

"The premise of the trade is still there," said Tim Gascoigne, head of portfolio management at HSBC Alternative Investments.

"There's a more interesting entry point for that trade," while the outlook for banks remains the same, he said.

According to the stock lending specialist Dataexplorers.com, more than 6 percent of British banks' equity is on loan to short sellers. This is down from more than 10 percent in March, but above the 4 percent level around the start of the year, indicating that hedge funds are still involved in this trade and are benefiting as the painful trends of July and early August begin to reverse.

The FTSE all-share bank index rose 14.2 percent from the end of June to Aug. 11, but has fallen 8.6 percent since then.

In contrast, the FTSE all-share mining index fell 24 percent from the end of June to Aug. 12, but has risen 10.9 percent since that date.

Banks "are going to struggle to raise enough equity to cover the next leg of the de-leveraging of their balance sheets," said Kinsey-Quick of Thames River, adding that the fundamentals on financials were still very weak. "We are looking at a multi-year boom in commodities and resources."

However, hedge funds will not be playing this trade in exactly the same manner.

For one thing, many funds are scaling back their positions to ensure that they do not suffer a repeat of March or July. Too many such months could scare off investors hoping for positive returns every month.

"Risk management ensures there's not so much of that trade now," Gascoigne of HSBC said.

Meanwhile, funds are starting to use other tools at their disposal to take advantage of bank sector woes.

One tactic that may be used is called pairs trades, in which a manager shorts one stock in a sector and buys another in the same sector. In this way, a fund can profit as a bank founders, regardless of overall trends in the sector.

"A lot of funds got burned so much. They've been paring back exposure," said Ferenc Sanderson, senior research analyst at Lipper, a Thomson Reuters company.

"But there's still some heavy betting going on in financials, betting that some financials will survive and others won't."