Hedgies adopt low profile to play Europe debt woes

By Laurence Fletcher

LONDON, Feb 3 (Reuters) - Hedge funds are steering clear of hotly debated credit derivatives and reverting to more orthodox bond plays so as not to invite more regulation from the many politicians who blame them for the global financial crash.

Fearing being seen as 'bringing down a country', funds are instead trading sovereign and corporate bonds as they hunt for less controversial ways of making money from market volatility.

'The larger funds have been really cautious in trading CDS. They don't want to find themselves in the newspaper, and let it become an issue with their client base,' said Jeff Holland, co-founder of fund of hedge funds firm Liongate.

Scouring through the track records and portfolios of hundreds of fund managers, firms such as Liongate select other funds to invest client money in, giving them a wide overview of trading strategies used by hedge funds.

At the height of Greece's debt problems in February last year, Europe's second-biggest hedge fund firm Brevan Howard, which now runs $32 billion in assets, told its investors it had sold out of 'meaningful' positions in CDS and bonds in Spain, Portugal or Italy. The firm declined to give further details.

'Hedge funds have been playing the bond spreads, which is less visible,' said Philippe Gougenheim, head of hedge funds at Unigestion, which invests in hedge funds. 'In the macro space they're definitely active on the bonds.'

While data on hedge funds' trades can be scarce, at the time of the Greek crisis last year hedge funds accounted for 12-20 percent of CDS activity, according to one hedge fund industry source, citing estimates from banks.

Hedge funds sprang up when rich investors thought of ways to hedge against losses in financial markets.

Many critics say the funds are still too lightly regulated and the largest funds fear further controversy could spark tightening of the rules.

Leading European politicians have blamed CDS -- a bet on the creditworthiness of a borrower -- for aggravating the debt crisis, allowing investors to speculate on a default rather than protect against it, their original goal.



INTERVENTION POWERS

Europe is approving a law giving the European Securities and Markets Authority powers to intervene in markets to ban practices, including naked selling of CDS, where the buyer does not own the underlying bond.

That comes after an EU report -- which was not published, despite protests from the hedge fund industry -- on sovereign CDS last year largely exonerated CDS markets for putting pressure on bond prices.

To avoid the risk of tighter regulation, many hedge funds are buying or short-selling sovereign bonds -- even of countries as seemingly stable as France and Germany.

'CDS is proving to be a more challenging market for traders, considering that governments are indicating that they could well change how the market is regulated,' said Scott MacDonald, at U.S.-based credit specialist Aladdin Capital.

The play on more sovereign trouble is just too good to ignore and funds are now looking beyond the so-called 'PIGS' (Portugal, Ireland, Greece and Spain), which have already yielded big profits for some investors as spreads widened.

'We're still seeing some funds using CDS but a lot have diversified because of politics and uncertainty in the regulation of CDS,' said Ben Funk, head of research at fund of funds firm Liongate, adding that cash bonds and currency also offer better liquidity.

He added: 'The general consensus is that there's more pain to go (for indebted European countries)... A lot of managers have taken off short Portugal or Spain positions, where it's almost a given there's going to be problems, and have moved to France or Germany.

'In those countries the spreads are so tight, but should there be instability in the periphery they'll move.'

(Additional reporting by Martin de Sa'Pinto in Zurich, editing by Sinead Cruise and David Cowell)

($1=.7224 Euro)

((To read the Reuters Funds Blog click on http://blogs.reuters.com/fundshub; for the Global Investing Blog click on http://blogs.reuters.com/globalinvesting/) Keywords: HEDGEFUNDS/EUROPE ([e-mail]; [phone]; Reuters Messaging: [e-mail]) COPYRIGHT Copyright Thomson Reuters 2011. All rights reserved. The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.