More to play for in hedge funds' favorite trade

A trader works on the floor of the New York Stock Exchange August 8, 2008.

LONDON (Reuters) - The hedge fund industry's trade-of-the-moment -- betting on falling financial stocks and rising commodities -- is set to offer further profits, despite July's setback, but managers may have to alter their tactics.

Hedge funds may well profit from betting July's bounce in battered financial stocks and decline in commodities was only a blip in a longer-term trend, since the fundamental reasons for disliking bank stocks and holding commodities remain 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 further poor numbers -- or are taking bets likely to be less painful if markets go against them.

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

An average 2.61 percent loss suffered by hedge funds in July, according to Credit Suisse/Tremont, was even worse for hedge funds than they suffered in March, when financials rose on hopes the U.S. Federal Reserve's bailout of Bear Stearns meant large banks would not be allowed to go bust.

Being short -- betting on a lower price in the future -- financials caught many hedge funds out that month, leading to industry losses of 2.11 percent.

However the rally proved temporary and, after a disappointing month of returns for hedge funds, financials resumed their downward spiral as writedowns continued.

In July the pain was most felt by long-short equity funds, among the biggest players of this trade, which lost 3.43 percent, while managed futures funds, which follow trends in global futures markets but which are hurt by sudden market reversals, fell 4.20 percent.

However, for those funds who have stuck to their financials/commodities bet, there is the opportunity for further profits.

"The premise of the trade is still there," said Tim Gascoigne, global 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."

STILL INVOLVED

According to stock lending specialist Dataexplorers.com, more than 6 percent of British banks' equity is out on loan to short sellers. This is down from over 10 percent in March but above the 4 percent level around the start of the year, indicating 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 Banks index .FTASX8350 rose 14.2 percent from the end of June to August 11, but has since fallen 8.6 percent.

In contrast, the FTSE All Share Mining index .FTASX1770 fell 24 percent from the end of June to August 12, but has since risen 10.9 percent.

"(Banks) are going to struggle to raise enough equity to cover the next leg of the deleveraging of their balance sheets ... The fundamentals on financials are still very weak," said Thames River's Kinsey-Quick.

"(In contrast) 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 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," said HSBC's Gascoigne.

Meanwhile, funds are starting to use other tools at their disposal to take advantage of some banks' woes.

One tactic may be via pairs trades, whereby 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 sector trends.

"A lot of funds got burned so much. They've been paring back exposure ... and dialing down leverage," 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."

(Editing by David Holmes)