Concerns over hedge fund bullishness on Europe

European equity hedge fund managers are more optimistic about their markets than at any time since the financial crisis ended, causing “deep worry” among some more skeptical investors.

Research by analyst DataExplorers shows hedge fund managers have 11 times more long positions on European equities than short positions.

This is over twice as optimistic as they were in January 2009, before MSCI Europe rallied 27% over 12 months, and 44% more upbeat than January 2010, before a further 8% run.

Leonard Charlton, manager of Dalton Strategic Partnership’s $170m Melchior European fund said: “This really worries me. In this business, whenever too many market participants have too similar a view, it is time to be very cautious about that view.

Magnus Spencer, partner at Dalton, said growth in earnings at many European companies is allowing hedge fund managers to remain bullish despite the sovereign issues.

Charlton is keeping Melchior within about 5% of market-neutrality.

“In the first quarter it will be right to be very prudent,” he said.

He has also bought index put options to benefit if markets tumble.

“With puts on indices, we would be in very good shape in a crisis scenario.”

Charlton estimates, at most, 20% of European hedge funds search out shorts to make profits these days, while most use them as protective hedges against long books.

“When one asks if shorting is a lost art these days, I believe no-one really thought it was an art in the first place. Yet, if you do not short sell, you cannot have confidence in non-correlated returns.

“If you can trade and manage risk actively, interpret the macro environment and go short, you should be able to make money whatever happens in 2011.”

Charlton does not rule out a handful of ‘risk-off’ periods in 2011, the likes of which hit equities hard in January, May and November last year as European sovereign debt levels came to the fore.

He dubs Spain “the real elephant in the room” this year, and says the markets will immediately turn their focus on it if Portugal is bailed out.

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