Expected Rotation Out of Bonds Rattles Hedge Funds

A mass investor rotation out of bonds, expected earlier this year, has finally materialized—to the dismay of some hedge funds that say they now need bigger cash stashes and an increased appetite for risk in order to trade successfully.

During the month of June, fixed income allocations fell to a four-year low, according to the American Association of Individual Investors, as major bond fund managers like Pimco experienced record withdrawals for the second quarter. That pullback sent places like emerging markets and high-yield bonds reeling—just as the Federal Reserve signaled plans to taper its easy-money policies within the coming years. Benchmark bond yields ticked up on that news, and in an unexpected twist, the stock market nosedived as well. 

It all amounted to heightened volatility in the markets after a sustained bull run, raising questions about the stock-picker's market that Delivering Alpha presenters, such as Leon Cooperman and Mary Callahan Erdoes, talked about at last year's conference co-sponsored by CNBC and Institutional Investor.

(Read More: Delivering Alpha: 2012's Best and Worst Ideas)

The first five months of the year, during which a bull run generated "easy money" by lifting the Standard & Poor's 500-stock index as high as 17 percent in late May, "are gone," said one long-short portfolio manager with billions under management. To play this market, he added, "you have to wind up trading in and out more than you want to."

Indeed,the average hedge fund, up 5.5 percent for year as of late May, is now up less than 4 percent on the year. The 10-year Treasury yield is now trading around 2.5 percent, interest rates on mortgages and other fixed-income products are also climbing, and the stock market gains have fallen to about 13 percent.

Trading nimbly in this environment, hedge fund managers said, requires keeping more capital at hand. Cash holdings increased 4 percent during the month of June,according to a recent AAII survey, amounting to a fifth of the average respondent's holdings—and prime brokers and traders say that hedge-fund borrowings have reduced in order to keep more cash on hand.

"We still expect flows to come to equity-based hedge funds, predominantly equity long-short," said Jon Kinderlerer, head of risk advisory in prime services at Credit Suisse. A long-short strategy involves bets both for and against equities to maximize returns regardless of the market.

Kinderlerer said he would also probably bet on quant funds, which use quantitative analysis generated by computer-based models to choose securities.

—By CNBC's Kate Kelly. Follow her on Twitter at

@KateKellyCNBC

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