Hedge Funds a Tough Act to Follow on Financials

Hedge fund managers like John Paulson who drove financial stocks into the ground a year ago are piling back into the stocks, but beware mimicking their moves.
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NEW YORK (

TheStreet

) -- Hedge funds that drove financial shares into the ground a year ago are piling back into the stocks, but average investors ought to be careful about mimicking their moves.

The first signal of a shift in hedgie sentiment came with the filing of a 13-F quarterly report for Paulson & Co. on Aug. 12. The hedge fund is run by John Paulson, who notoriously made gobs of money betting against housing and financial firms last year.

But by June 30, Paulson held $3.5 billion worth of long positions on names that risked losing the most from the housing bubble and financial market's collapse --

Bank of America

(BAC) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

,

Goldman Sachs

(GS) - Get Report

,

Capital One

(COF) - Get Report

,

Regions Financial

(RF) - Get Report

,

Marshall & Ilsley

(MI)

,

People's United

(PBCT) - Get Report

,

First Horizon

(FHN) - Get Report

,

Fifth Third

(FITB) - Get Report

,

State Street

(STT) - Get Report

and

SunTrust

(STI) - Get Report

.

Six of those companies are still covered by the government's bailout blanket, and one of them, Bank of America, is the second-largest traditional bank recipient. Paulson also reportedly acquired a 2% stake in

Citigroup

(C) - Get Report

, the top bank recipient of bailout funds.

Next came an Aug. 24 Goldman Sachs report on hedge funds' second-quarter positioning, noting a broad shift in hedge fund strategy. As banks flooded the market with stock for capital raises, the fast money set had become a voracious consumer. Improving economic data and stability in the markets led to higher pricing as well, and hedge funds were forced to cover short positions they had held for the five previous quarters.

"Hedge funds are no longer net short financials," Goldman analyst David Kostin asserted, recommending that clients follow the industry's lead.

As traditional bank stocks gained ground -- with the KBW Bank Index up more than 22% this quarter -- even the most speculative names

began to rebound

tremendously. In the span of two weeks,

American International Group

(AIG) - Get Report

and

Fannie Mae

more than doubled, while

Freddie Mac

surged nearly 90%. The three stocks closed trading on Aug. 28 at $50.23, $2.04, and $2.40, respectively.

The government owns about 80% of each of those firms. Though their future remains unclear, the capital structure offers little protection for common shareholders, who may be wiped out completely in a restructuring plan.

"I guess they ran out of reasonable institutions to bid up so they moved on to Fannie, Freddie, AIG," said Dan Alpert, managing partner for Westwood Capital. "It makes no sense."

CIT Group

(CIT) - Get Report

, a troubled commercial lender that teetered on the brink of bankruptcy recently, also climbed 24% over the same time frame. Even the pink sheets of failed banks

Washington Mutual and Lehman Brothers

gained ground recently.

It was clear something was afoot. And that's the trouble with chasing hedge funds -- an industry known for making risky, speculative bets, then booking heady profits and exiting positions as quickly as they got in.

"Those are simply short-term momentum and trading events," says Walter Gerasimowicz, who manages a $100 million long/short hedge fund with Meditron Asset Management. "The average investor should avoid them completely."

A similar trend occurred with oil last summer -- the commodity reached $147 by July 11, then quickly crashed 20% by the time the next month's contract was up for bidding. A year later, it was trading at just half that level.

Similarly,

AIG, Fannie and Freddie

all lost a huge portion of the value they appeared to have collected in just a few sessions hence, potentially burning investors that bought in at the height or failed to exit positions quickly. CIT, WaMu and Lehman followed suit.

More traditional banks with less government ownership also have less volatility. Still, investors shouldn't be surprised if there's a near-term correction, given the quick, sharp run-up in the second quarter, lingering economic issues and the growing chorus of commentary about a market that seems overbought.

"The number of people calling for a correction seems to be multiplying exponentially, but when you ask why, they're saying that a correction is overdue and point to the recent rally as their backup reasoning," says Robert Pavlik, chief market strategist at Banyan Partners.

Craig Lilly, a financial services expert at the law firm of Squire, Sanders & Dempsey, notes that while hedge funds' 13-F reports may be released in August, they reflect positions that were held over a month ago -- leaving ample time for those positions to change.

Hedge funds are also not required to disclose holdings under 5%, meaning that a fund may have had a position in a particular stock for quite awhile. If they added to the position enough to breach the 5% mark during the quarter as prices declined, that's when it would have to be reported.

"They may have acquired 4% months ago and acquired another 1% now," says Lilly. "They may have bought it in July or dollar-cost averaged it over several weeks, meaning the pricing was very different."

As for average investors considering those stocks today, Lilly says "it's a dangerous investment to make ... unless you're very well informed," adding that "there's still a lot of unrest in financial institutions right now."

Those who remain bullish on the financial sector's near-term prospects still shouldn't "just pick a symbol" arbitrarily, says Gerasimowicz. He suggests average investors committed to following the stock picks of savvy investors -- whether John Paulson or Warren Buffett and

Berkshire Hathaway

(BRK.A) - Get Report

-- must be willing to "delve into the balance sheet" themselves. They might also want to wait for a pull back in pricing to enter financial stocks, he adds.

"I believe for the average investor it's late in the game to even consider getting in," says Gerasimowicz, whose fund has a long position in US Bancorp. "I think they would be hurt."

-- Written by Lauren Tara LaCapra in New York

.