* ECB bets, geopolitics take place of fundamental analysis
* Stock correlation rises; futures drive market
* Stock pickers struggle as market swings in unison
* Macro funds deliver strong returns - Lipper
By Francesco Canepa
LONDON, Sept 4 (Reuters) - The dreaded return of "risk on, risk off" - investor shorthand for hard-to-analyse markets that swing in tandem with big headlines - is frustrating European stock pickers, who had hoping for a comeback after struggling for years.
Frantic speculation about monetary policy in Europe and geopolitical tensions from neighbouring Ukraine to the Middle East have been dominating investor attention. That has left traders poring over news reports and relegating fundamental analysis to the sidelines.
Correlation between shares in the Euro STOXX 50 index has surged to 67 percent currently from a seven-year low of 59 percent in late June. And two future contracts were traded on the index for each of underlying share in August, up from around parity in June and above the historical average, Thomson Reuters Datastream data showed.
While the current environment is a far cry from the jittery days of 2011 - when stock correlation was 80 percent and the euro zone's very survival was in question - directional bets on entire indexes are increasingly driving the market, causing shares to move in tandem.
This has created choppy waters for investors who pick individual companies at a time when they were expected to benefit from a calmer global macro background.
The average long-only funds invested in continental European equities returned a negative 1.2 percent over July and August. They lagged even passive funds, which simply track the market and were down 0.7 percent, Lipper data showed.
Long-short hedge funds, which can bet on declines in share price, held up better, delivering a 2.2 percent positive return. Macro funds outperformed, returning 4.1 percent.
"This is the toughest market I've been into," said stock picker Can Elbi, portfolio manager of the Julius Baer Europe Focus Fund. "Since the end of February there has been a barrage of geopolitical tail risks that have come from nowhere. And that just convolutes the whole analysis and creates a highly correlated risk-on, risk-off environment that is not good for a stock picker."
The worst performer in the Lipper poll of 144 long-only equity funds was the Cavendish European A fund, which returned a negative 6.6 percent over July and August. The fund's largest holding at the end of June was the now collapsed Spanish telecoms company Gowex, Thomson Reuters data showed.
Among the thriving macro funds, with the Opportunity MIDI Performance fund returning around 20 percent over the same period.
Macro traders have been using DAX futures as a liquid instrument to express their view on the Ukraine-Russia crisis, because of Germany's perceived exposure to eastern Europe and despite the fact that DAX companies only get 2.4 percent of their revenue in the region, according to Datastream data.
The futures-to-cash volume ratio on the DAX shot up to 1.4 times, compared with a long-term average of 1 once futures expiries are excluded, as the index swayed between an all time-high and a 10-month low.
The Euro STOXX 50 also fell 10 percent between late June and mid August, weighed down by poor economic data. It has since recouped most of those losses as markets came to expect fresh ECB steps to stimulate the economy.
Those bets were partly rewarded on Thursday, when the ECB cut interest rates to a record low and introduced a new scheme to push money into the flagging euro zone economy, although it stopped short of a full-scale quantitative easing plan.
The market's fixation with central bank policy means the potential for fresh bumps along the road is high if the current bets on quantitative easing by the ECB are frustrated while the Federal Reserve sticks to its plan of gradually tightening policy.
"We expect increased volatility in markets as investors attempt to front-run the central banks' eventual decision on rates," said Oliver Wallin, director of fund manager Octopus Investments.
"If the central banks' forward guidance policy was working properly, this volatility should be managed, but we suspect there is plenty of room for error in managing the communications between the bank and the market."
To adapt to this market environment, Stanhope Capital has increased its allocation to equity fund managers who adopt a macro overlay in their analysis and can bet share prices will fall.
"For European equities the key catalyst has got to be the risk of deflation and how the authorities respond to that," Jonathan Bell, chief investment officer at Stanhope Capital, which oversees approximately $8.5 billion on behalf of wealthy families.
"Until we get a real feel for what the ECB is prepared to do, it's going to be very difficult to make any headway unless you get a return to growth and I don't see it at the moment." (Reporting By Francesco Canepa; Editing by Larry King)