LONDON Hedge funds are switching their short positions away from UK banks to areas such as insurers and defensives, but their impact on the market is becoming less marked as the once-booming industry rapidly shrinks.
Short-selling bank shares was a profitable trade in a bleak 2008 for hedge funds, but with stock prices having fallen so sharply and tens of billions in writedowns announced, many funds think UK banks may have 'kitchen-sinked' their bad news and there is more chance of the shares rising.
Shorting means selling borrowed stock in the anticipation the price will fall, allowing the stock to be bought back at a profit.
This week high-profile hedge fund manager Crispin Odey, who last year won bets on falling bank shares, revealed he has been buying into UK banks because he thinks they are now so cheap.
"Given that on the other side of this disaster these banks can earn multiples of their current share price, the risk/return is wrong... Given time and distance, they will be fine," Odey wrote in a letter to investors.
Many funds are closing their UK bank shorts and moving to sectors such as insurance, which outperformed banks in 2008 -- the FTSE 350 Life Insurance sector .FTNMX8570 fell 43 percent while the FT350 Banks sector .FTNMX8350 fell 57 percent.
While insurers have reported some writedowns, some hedge funds are betting the sector will need to raise more capital or cut dividends. On Wednesday shares in Legal & General fell when a trading update failed to reassure investors on its capital position.
Hedge fund firm Lansdowne Partners this week increased its short position in Legal & General (LGEN.L) and also has shorts on Aviva (AV.L), Prudential (PRU.L) and Old Mutual (OML.L).
Funds are also targeting defensive sectors whose valuations have been pushed up by mutual funds, which tend to have more constrained mandates and therefore have to seek out growth in the market, even in bad times.
"A lot of shorts have come off Anglo Saxon banks. There is a feeling that Anglo Saxon banks have marked to market and provisioned more aggressively," said Christopher Fawcett, chief executive of Fauchier Partners and a trustee of the Hedge Fund Standards Board.
"There has been an increase of shorts in the insurance sector -- it's a classic second phase play ... Managers have also gone short on some defensive companies on the basis that they are expensive relative to the rest of the market."
Since the lifting last month of Britain's temporary ban on new short positions in financial stocks, few hedge funds have dashed back to shorting UK banks.
According to research firm Data Explorers, while the aggregate amount of UK bank stock on loan -- an indication of short interest -- is moderately higher now than for most of the ban, it fell between the end of January and February 17.
"Some hedge funds have covered short financial positions and others reduced them substantially, a few are maintaining some specific name shorts in UK and U.S. financials," said Cem Habib, fund of hedge funds manager at Altedge Capital.
In contrast, the insurance sector has seen the amount of stock out on loan rise 75 percent from the end of January, albeit from a low base.
While the practice was attacked by some politicians and commentators last year, who blamed it for confidence-sapping falls in some banks' share prices, short-selling is having less of an influence than before on stock prices.
The hedge fund industry shrank to $1.41 trillion (987 billion pounds) at the end of 2008 from $1.87 trillion at the end of 2007, according to Hedge Fund Research, after record poor performance and heavy outflows.
Further outflows are expected at the end of the first quarter, limiting funds' ability to make new trades because they have to focus on raising cash to meet these withdrawals, while prime brokers have also cut back leverage to funds.
"Shorts are quite a bit smaller. Hedge funds are smaller and balance sheet utilisation is a lot smaller," said Altedge's Habib. "A typical fund that a year ago was 100 percent long and 80 percent short is now 40 percent long and 30 percent short."
(To read the Reuters Hedge Fund Blog click on blogs.reuters.com/hedgehub; for the Global Investing Blog click here)
(editing by John Stonestreet)