* Hedge funds reverse bets against stocks
* Funds fall far short of S&P gains in 2012 -Credit Suisse
* Hedge funds increase bets on volatile, higher-risk stocks
By Edward Krudy
NEW YORK, Sept 21 (Reuters) - Many U.S. hedge funds that have the lagged the stock market rally in 2012 are now buying riskier stocks and commodities - and using more borrowed money - in an effort to play catch-up.
Funds have cut cash holdings and reversed broad bets against the surging market. If the shift in the $2 trillion hedge fund industry continues, it could drive asset prices even higher.
"We've been watching for months for signs of a catch-up in risk and are at last starting to see it, as funds raise risk to markets to lessen the risk of missing the markets," Philip Vasan, global head of Credit Suisse's prime brokerage, told a conference call of several hundred hedge fund clients and their investors on Wednesday, according to a transcript of his remarks provided to Reuters.
Through the end of August, hedge funds gained around 4.5 percent compared with total returns of 13.5 percent in the benchmark S&P 500 Index , according to Credit Suisse. Hedge funds focused on credit strategies have been the best performers, with returns of more than 7 percent this year.
Hedge funds started to become more aggressive over the summer, in the run-up to a well-telegraphed move by the U.S. Federal Reserve to pump stimulus into the U.S. economy and as the European Central Bank stepped up efforts to reverse the debt crisis in the euro zone.
So far, 2012 has been a year that has flummoxed many seasoned market-watchers. They feared a repeat of 2011, when markets sold off sharply on concerns the euro zone would collapse, sparking a massive financial crisis and a deep global recession.
But as of Friday's close, the S&P 500 has rallied 16 percent since the start of the year, and many emerging markets and developed European markets have seen dramatic reversals of fortune over the summer. About 7 percent of the S&P's gains have come since early August.
Hedge fund exposure to higher risk, volatile stocks that tend to exaggerate market moves - such as financials and small caps - has reached levels not seen since the spring. Holdings in those so-called high beta stocks rose 40 percent in August and such stocks now represent nearly a third of funds' net U.S. exposure, according to Credit Suisse.
Leverage has increased modestly, hitting 2.6 times capital after remaining around 2.5 times during the summer, according to Vasan. That is still far below levels seen prior to the 2008 financial crisis. In a sign of some bullishness, hedge funds have moved more money out of cash, with the excess cash level falling below 21 percent for the first time since the spring.
More hedge funds are long the market than in the summer, as the long-short ratio is up to 38 percent after slumping to 25 percent over the summer. This indicates that more investors are betting that the U.S. stock market will continue to rise.
The repositioning has borne fruit. Long-short funds captured two-thirds of the MSCI World Index's gains in August, compared with 7 percent in June. Returns for long-short equity funds climbed steadily, hitting 3.2 percent in the middle of September from below 0.3 percent in June.
Credit Suisse prime brokerage serves about 400 hedge fund clients that range in size from $100 million to several billion dollars. Vasan estimates that his monthly client calls represent about a third of the industry's $2 trillion in net assets.
BOTH FEET IN WATER
Performance at equity hedge funds has started to accelerate. In August equity-focused funds gained 1 percent compared with 0.5 percent across the whole industry, according to data from Research eVestment Alliance. It was the third consecutive monthly gain, they said.
Greenlight Capital Offshore, a mid- and small-cap hedge fund run by David Einhorn, is one of the best-performing funds this year. It gained 4.1 percent in August and was up 10.4 percent in the first eight months of the year, according to a weekly hedge fund review by HSBC.
Despite early signs of greater conviction on the part of hedge fund managers, flows into hedge funds - money that investors are putting to work in the area - have still not seen a significant pick-up, said Vasan.
Through the three months ending in July - the latest period for which data is available, $16.8 billion flowed out of hedge funds, according to Research eVestment Alliance.
But Vasan said he is seeing an uptick in enquiries from investors about investing in hedge funds. They are also seeing strong enquiries at the firm's capital services team, which raises money for hedge fund clients from investors such as family offices, endowments, and insurance companies.
"Although not yet reflected in significant flows, investors continue to do a great deal of advance work this month, to be prepared to allocate when they identify a catalyst for writing the check," Vasan said on the conference call.
"We've considered today a change in risk stance that is very much an extension of what was under way - from a toe in the water, to a foot, to both feet - with central bank intervention the catalyst," he said. "We'll see if this has legs, and if so how investors follow."