* Hedge funds turn bullish, play pairs trades
* Long/short strategy up 7 pct year-to-date, outpaces market
* Buy the unloved, sell the darlings -Unigestion's Rousselet
* Go long Spanish banks/short German banks-Dexia AM's Cuchet
PARIS, Feb 4 (Reuters) - Hedge funds are trimming outright negative bets on stocks in favour of a strategy more suited to a rising market but which could still make a profit if the rally falters.
Combing through the market to buy stocks, sectors or indexes expected to outperform and sell peers set to fall behind, the funds bet on the gap in performances -- a strategy that is already outpacing the market in 2013, Deutsche Bank data shows.
"You buy the undervalued companies, on which investors underestimate the earnings potential, in sectors that have been avoided by the market, and on the other side of that position, you identify the darlings of the market, the excessively expensive stocks among which you can find good short opportunities," said Nicolas Rousselet, head of hedge funds and managing director at Unigestion.
Short-selling involves borrowing an asset from a long-term holder such as a pension fund then selling it. The aim is to then buy it back at a cheaper price and pocket the difference.
However, given the scale of the broad market rally since mid-2012, which has seen world stocks surge about 23 percent, pure short-selling has been suffering, ending the year as the worst hedge fund strategy in 2012, down 16 percent.
According to New York Stock Exchange data, short interest -- the quantity of shares sold short -- has fallen 13 percent on Wall Street since mid-2012, with the trend accelerating in December when short interest dropped 4.8 percent.
Short sellers have also been closing positions in Europe, with short interest on the STOXX Europe 600 falling to 2.3 percent of shares out on loan, from 3 percent in early July.
Expectations of further gains in stocks this year, as investment flows into the asset class accelerate, is prompting hedge funds to abandon pure short selling and turn instead to a "long/short" approach.
"The shorts have capitulated. While pure shorts have gone quiet, we're seeing a big revival of the 'long/short' strategies. Most of the short interest you see in the market at the moment is coming from people playing pairs trades," Unigestion's Rousselet said.
Trading the gap between the performance of both positions creates a natural hedge against the overall market direction, limiting the damage in case of a market correction and greatly reducing the portfolio's volatility.
"Regardless of the market's overall direction, you're making money as long as your 'long' pick outperforms your 'short' pick, on the upside as well as on the downside," said David Thebault, head of quantitative sales trading at Global Equities.
STOCK PICKERS THRIVE
After struggling for years as the jolts of the euro zone crisis dictated market direction, stocks pickers are thriving again, with the focus back on balance sheets.
The degree to which shares move in unison, or correlation, has fallen back to 2007 levels, boosting the European long/short equity strategy, up 7 percent so far in 2013, Deutsche Bank data shows, double the broad market gains.
According to Schroders, which launched a new long/short equity fund last week, long/short currently ranks first among hedge fund segments for projected net inflows in 2013.
One of the most popular pairs trades recently, hedge fund managers said, has been to buy shares of German car makers such as BMW and Daimler and short stocks of troubled French automaker PSA Peugeot Citroen.
The trade has been very profitable in the past few years as the German car makers benefited from their significant exposure to emerging markets while Peugeot, which had focused on the European market, suffered from the region's crisis.
However, as the overall market is widely expected to recover further this year, more and more hedge funds are buying shares of battered firms instead, and shorting stocks that have been resilient during the crisis and which look relatively pricey.
This hunt for "recovery stories" has sparked rotation within sectors, with both Renault and Peugeot surging 10 percent since the start of 2013 while BMW is slightly down.
Long/short strategies also work at a regional level, with hedge fund managers playing the resurgence of equities from peripheral European markets, using country index derivatives and exchange-traded funds.
Societe Generale strategists recently recommended a long/short pairs trade with a long position on France's CAC 40 index and a short position on Germany's DAX, betting on the French market's catch-up rally.
"Geographical pairs trades work well at the moment, said Fabrice Cuchet, global head of alternative investments at Dexia Asset Management. "One of the long/short ideas we've been playing was to buy Spanish banking stocks, as the country's debt yields fell, and sell German banking shares," he said.