NEW YORK ( TheStreet) - For U.S. bank stock investors, 2011 was a bad year with shares of many of the largest banks falling nearly 40%. Overall, declines in the sector meant that it underperformed the S&P 500 Index by a mile. But for some of the largest hedge fund investors -- which jump in and out of company shares to gain outsized returns -- bank stock volatility set up them up for large gains. Others threw in the towel or got bullish on the sector at inopportune times.
Overall, the Financial Select Sector SPDR ( XLF) exchange traded fund fell over 18% down in 2011, leaving even the smartest investors perplexed on how to make money on bank stocks. After a strong start to the year added to 2010 gains, the index plummeted in August after Standard & Poor's cut the ratings on U.S. debt, slamming bank stocks by over 17% from Aug. 2 through Aug.8. After a choppy summer and fall on issues like ratings downgrades, a worsening of the European debt crisis and increasing legal liabilities related to mortgage assets for bellwethers like Bank of America ( BAC) , Citigroup ( C) , Goldman Sachs ( GS) , JPMorgan Chase ( JPM) and Morgan Stanley ( MS), bank stocks started an epic rally in late November that's carried into 2012. Of the nation's largest banks, Bank of America has seen its shares rally the most in 2012, with its stock rising over 40%, outpacing the 20%-plus gains of Citigroup, Morgan Stanley and Goldman Sachs, in addition to the more muted 10%-plus gains of JPMorgan, Wells Fargo and Capital One Financial ( COF). Those gains help to soothe 2011 losses, where Bank of America shares were halved and Citigroup, Goldman Sachs and Morgan Stanley did little better. Of the biggest banks, only Capital One Financial posted a 2011 gain, boosted by its now Fed approved purchase of ING Direct. Overall, the Financial Select Sector SPDR is up 12% in 2012. For hedge fund investors who recorded their worst year since 2008, the volatility in banking stocks and markets proved to be a challenge. Hennessee Group, an adviser to hedge fund investors, said in January that its Hennessee Hedge Fund Index dropped 4.3% in 2011, compared to a flat performance for the S&P 500. It was the second year in a row that hedge funds failed to beat equity indices. Hennessee Group noted that equity markets were driven by macro issues in 2011, "which overshadowed strong corporate earnings and an improving economy." The firm said that several hedge funds expressed frustration in long positions of companies, where they beat expectations but still saw share prices decline more than the broader indices. And while stocks rallied sharply higher in October, managers ended 2011 with low exposure to stock markets, missing on a late-year rally. Hedge fund magnate John Paulson of Paulson & Co. had a famously bad 2011, with his flagship fund drop 51% in 2011 after several bets went terribly wrong. Here's a look at the bank investors who bought and sold shares of the nation's four largest banks, with insight into what investing strategies work in a sector that can turn bearish to bullish on a dime, and vice versa. For more on bank stocks, see five booming bank stocks poised to fall and five bank stock value plays.