LONDON/PARIS Hedge funds' negative bets on European shares have tumbled to a level not seen since before the global financial crisis began in 2007, signalling their strongest conviction for years that the market will rise further.
It means long/short hedge funds, which bet on which stocks will rise or fall, have taken a strongly bullish tilt to take advantage of both a rising market and of the lower correlation among stocks brought about by continued monetary support by the U.S. Federal Reserve.
According to data from Markit, the overall value of "short positions" or shares out on loan on the benchmark STOXX Europe 600 has dropped to $144 billion, its lowest since Markit started to monitor the data in mid-2006, and down from $167 billion two years ago.
Short sellers borrow securities and sell them, betting they will be able to buy them back at a lower price before returning them to the lender and pocket the difference.
When factoring in the 35 percent rally in the STOXX 600 over the past two years, the overall value of shorted positions since September 2011 has tumbled by two-thirds.
"The muted borrowing demand today is the new reality. In this prolonged bull market, it has been hard for short sellers to bet against a rising tide," Alex Brog, director at Markit, said.
The hedge funds' bullishness means that for each shorted stock, there are 15 "long" positions, i.e. bets the market will rise. This compares with one short for 10 long positions in September 2011, at the height of the euro zone debt crisis, according to Markit data.
This represents a big change as not all funds have a mandate that allows them to take short positions.
"People have increased their long positions in sectors that were ridiculously cheap and with good fundamentals," said Roberto Botero, a London-based director at Sciens Capital, who sees hedge funds as even more positive on U.S. equities.
"Almost everyone in U.S. equity long/short is extremely bullish. They believe that the housing market has turned and once it's turned there's no stopping it."
Top performing long/short funds this year include John Armitage's Egerton European Equity Fund with gains of more than 20 percent to September 20, and the flagship fund at Larry Robbins' Glenview Capital, up 30.7 percent to the end of August, performance data seen by Reuters shows.
Meanwhile, Lansdowne Partners' $10 billion Developed Markets Fund - widely considered to be the largest long-short hedge fund in Europe - is up 19.7 percent to September 20, putting it on course for its best year since 2009, according to the data.
The environment for equity hedge funds is set to improve further, thanks to the more stable market conditions created by the Fed's decision to extend its monetary support, which allows investors to increasingly focus on corporate fundamentals rather than the macroeconomic backdrop.
The long/short strategy has struggled in the past few years as macro issues were dictating market moves, but there has been a strong revival of the approach this year, with brisk inflows coming into the funds as volatility dropped and stocks started to trade more independently of each other, allowing stock pickers to thrive.
According to data from Eurekahedge, long/short hedge funds have attracted $42.6 billion of net new money in the first eight months of the year, representing more than half of all inflows into hedge funds overall.
The sector is up 6.5 percent this year against a 3.9 percent rise in the average fund, according to industry tracker Hedge Fund Research. Over the last five years, however, they have returned below 3 percent per annum, less than the 3.4 percent the average fund made.
Correlation between the S&P 500 stock index and its components has dropped back to pre-crisis levels and expectations of future swings in share prices, as measured by the CBOE Volatility Index .VIX, or VIX, has also fallen back to early 2007 levels. link.reuters.com/fyn43v
"If you look at intra-stock correlations, it would suggest the market is becoming more fundamentally driven," Simon Nicholas, senior fund manager at Brown Shipley, which manages assets worth around 4 billion pounds.
"We can still expect some volatility (when the Fed start to reduce QE) but...I would expect to be reducing passive elements in favour of stock picking going forward."
(Graphics by Francesco Canepa, Vincent Flasseur, editing by Nigel Stephenson and David Cowell)