European hedge funds have been cutting back some of their bets on stocks on concerns over the outlook for economic growth after last year's profits bonanza, with some fearing markets could still drop below 2009 lows.
Large bets on rising stocks helped hedge funds make gains of nearly 19 per cent last year, according to Credit Suisse/ Tremont, but prime brokers say funds have grown more cautious in recent weeks in areas such as US and European stocks.
"Exposure has been cut back. Some (funds) have made a lot of money last year," said one prime broker, asking not to be named. "Some are sceptical about the length and breadth of the recovery," the broker said.
With the eurozone economy growing just 0.1 per cent in the fourth quarter, many funds are nervous about the economic outlook, particularly after Greece's debt crisis.
Banks in particular could suffer as funding costs rise and margins are squeezed, after the financial sector was a top-performer in last year's rally.
Giving up last year's gains would make it harder for them to earn lucrative performance fees and could persuade clients to pull out their cash.
Hedge fund manager Crispin Odey, who made huge gains from banks and other stocks after correctly calling last year's bull market early on, recently told clients he was "now much less sure" that last March's low of 3,460.71 for the FTSE-100 index .FTSE was really the bottom.
"The problem for equities is that they depend upon profits growing, and that demands that the economies are growing," the founding partner of Odey Asset Management said.
According to Colin McLean, manager of SVM's Highlander hedge fund, markets could "quite possibly" fall below last year's low. "Rallies within bear markets can be quite large and quite sharp," said McLean, whose funds are around 10 per cent net short banks. "The best indicator is from financials. They're still a concern."
One prime broker, who asked not to be named, said hedge funds were short European and US stocks on concerns over growth and consumer spending, but long emerging markets and commodities.
"Returns in emerging markets, particularly Asia and Latin America, represent an opportunity for hedge funds," said Mark Harrison, European head of prime finance at Citigroup.
However, some funds are worried about banks, which were one of the sectors to lead last year's dramatic market rebound, almost tripling from trough to peak, but which have since lost around 10 per cent.
A research report by Morgan Stanley and Oliver Wyman released on Tuesday predicted as a base case a 10-15 per cent drop in investment banks' underlying revenues as one-off gains pass and margins tighten.
Describing 2010 as a "pivotal year" for investment banks, it also forecast a base case that regulation could cost the industry around four per cent of its return on equity, although this could be as much as eight per cent.
Odey, who has cut his stake in Barclays and sold other banks, said improvements in banks' margins on lending had been almost cancelled out by rising funding costs.
"Therefore banks who over-lent in that 2002-2007 period and had small deposit bases relative to loans are still in trouble," he said.
And there is further pain to come, he warned, as banks roll over cheap bond issues. Banks need to raise as much as £750 billion in the next three years to support balance sheets and liquidity as the UK government prepares to wind down support for the sector.
Financials fund manager Blue Planet said it had slashed equity exposure in its European investment trust to 20 per cent in February from 96.7 per cent in December, though this has crept up this month on concerns over Greece's debt crisis.