Hedge funds are cashing in some of their chips after enjoying a bumper first quarter, wary that a sudden change in market sentiment could see them take the sort of losses suffered in last year's volatile markets.
Hedge funds returned 5 percent in the first two months of the year, the best start to a calendar year since 2000 according to Hedge Fund Research, as the European Central Bank's 1 trillion euro ($1.3 trillion) cash injection boosted assets across the board.
Some star names recorded huge gains. Crispin Odey's Odey European fund gained 21.1 percent and Johnny de la Hey's Tosca fund rose 13.7 percent to mid-March, while Michael Hintze's $1.4 billion CQS Directional Opportunities fund was up 13.9 percent to end-February.
Many managers remain positive on markets, but in a number of cases have opted to trim their bets, influenced by sharp volatility last year during the euro zone debt crisis that saw the average fund lose 5.3 percent and some more bullish funds take much bigger losses.
"Over the last week or so we've actually seen (risk) come off a bit," said Paul Harvey, European head of sales in prime finance at Citi.
"We all want this rally to continue but we are all relatively cautious about the broader macroeconomic environment and the political environment, and uncertainty certainly prevails."
Many managers came into this year with low levels of risk, missing out on the start of the rally after underestimating the impact on markets of the ECB's so-called Long Term Refinancing Operations, designed to avoid another credit crunch.
As markets continued to rebound during the first quarter, however, a number of funds hiked their bets, in particular favoring the commodities and financials sectors, according to one fund of funds manager.
According to Citi's Harvey, equity long-short funds upped net exposure - the difference between bets on rising stocks and falling stocks - to 73 percent, and gross exposure - the sum of long and short bets - to 165 percent this quarter.
However, in some cases this has now come down. "We've seen some reductions but (I) wouldn't say (a) huge swing to risk off," said one prime broker who spoke on condition of anonymity.
CQS's Australian founder Hintze is among those to have struck a more cautious tone recently.
In his February investor report he wrote: "We remain broadly constructive on markets but are mindful of potential volatility that could arise due to the ongoing macro uncertainty."
Managers are worried the euro zone debt crisis could flare up again, that China's economic growth is slowing, and that tensions between Iran and the West could lead to further gains in the oil price that could reignite inflation.
David Stewart, chief executive of Odey Asset Management, told Reuters the firm remained bullish on equities, preferring them to credit.
But he added: "When the market has had a good run then you often trim a bit. We haven't changed our view. We know it's going to be difficult ... Equities are the right place to be ... The LTRO has been pretty favorable to equities."
Some funds are also beginning to look at put options as a way of protecting their portfolios from market falls, encouraged by the cheaper pricing of options thanks to a fall in volatility since the autumn. The VIX .VIX, a gauge of volatility, is down by two-thirds since early October, for instance.
"Some people who haven't used it historically (are looking at using options)," said Morten Spenner, chief executive of fund of funds firm International Asset Management. "As the pricing has come down because of the VIX, it's become more attractive for people to look at it.
"People are careful having made gains," he added. "Everyone will now agree that the situation does look more positive, but there are still quite a few things to solve."
Other hedge funds remain bearish. Tom Wilkes of Reuters reports, Hedge fund COMAC stays bearish despite rally:
Hedge fund COMAC Capital, the $5.2 billion macro fund run by Colm O'Shea, is bracing for a fresh round of turmoil in European markets, people familiar with the fund said, and is sticking to its bearish strategy despite losing out in this year's rally.
London-based COMAC, down more than 5 percent in the period up to mid-March this year, believes the flood of cheap central bank cash into parched markets is only a temporary fix for Europe's ills, and masks the region's poor economic prospects, these people said.
Most hedge funds are returning to winning ways in 2012 thanks to the rally in equity and bond markets and a bullish stance. The average hedge fund has risen 5.03 percent from the start of the year up to March 15, according to the HFRI Fund Weighted Composite Index.
Bullish funds have benefited from the European Central Bank's one trillion euro cash injection into the financial system and greater confidence that policymakers have finally stopped the Euro zone debt crisis from spiralling further out of control.
But some macro funds are positioning themselves for a new downturn in Europe, at the same time as they see an improved economic outlook for the U.S.
Many have bought options linked to volatility, which will rise in price if there is a resumption of the panic that racked markets for most of 2011, people familiar with the sector said.
"A lot of these funds think all this quantitative easing is just a temporary fix and the underlying problems are still there," one of the macro-investors said.
Macro funds make money by wagering how economic trends will play out across asset classes including in rates, currencies, commodities and equities, and are among the best-known.
Well-known funds in the sector include Brevan Howard, Moore Capital and Tudor Investment, as well as George Soros' Quantum Fund, where O'Shea used to work as a macro trader.
COMAC has made several successful calls in the past. It returned 5 percent in 2011 compared with a fall of more than 5 percent booked by the average fund.
It has returned an annualised profit of upwards of 8 percent since its 2005 inception, data seen by Reuters shows.
O'Shea, who read economics at the University of Cambridge, also performed well in 2008 after several successful bets including one on falling U.S. interest rates.
According to its website, COMAC invests across global markets to try and capture "directional market movements that commonly have a strong fundamental reasoning based upon economic and political analysis."
Investors looking for protection against volatile and uncertain markets have made macro funds among the most popular strategies this year.
In a recent survey conducted by Credit Suisse, investors said macro was the most sought-after strategy in 2012, while also predicting that they would be the best performing.
COMAC declined to comment.
So what is going on? On Monday I wrote that most hedge are capitulating, getting bullish on stocks. Is this about to change? I don't think so. While some funds are booking profits, most of them are underperforming, forced to play catch-up. The Dow Jones Credit Suisse Core Hedge Fund Indexes show that L/S Equity hedge funds were down 2.3% MTD in March. Most of these hedge funds got screwed shorting this market (click on image to enlarge):
But what about funds like COMAC? Are they right in warning that quantitative easing is a "temporary fix"? Bloomberg reports that European leaders signaled rising confidence that their region’s crisis is near an end, while Federal Reserve Chairman Ben S. Bernanke warned that a U.S. recovery isn’t assured.
While it's too early to claim victory, the US economy is well into recovery mode. As for Europe, they averted a crisis of confidence but they still have a lot of work ahead of them to tackle the debt and more importantly, unemployment crisis.
But the key point which I want my readers to understand, even if you're skeptical on quantitative easing, there is no denying that as global central banks pumped up the jam, it has helped banks shore up their balance sheets by reflating risk assets and we're seeing a pretty good US recovery right now. This isn't a "temporary fix", it could well be the early innings of a decent, albeit muted, economic recovery and a liquidity melt-up in stocks.
My point is simple, there is nothing wrong with taking profits, but stay vigilant as the dips will be bought hard and this thing can easily explode up. Of course, some think the opposite will happen.
Below, Jeremy Hill, chief operating officer of Societe Generale's U.S. research department, talks about hedge fund trades 'crowded' on risks, investor sentiment and strategy. Hill speaks with Deirdre Bolton on Bloomberg Television's "Money Moves."