* European banks' performance: reut.rs/2cGYHmX
* Deutsche Bank vs peers: reut.rs/2du7sPY
* U.S. vs European banks: reut.rs/2a27exm
* European banks up 20 percent from July lows
* Traditional banks, Nordics outperform; i-banks struggle
By Alistair Smout
LONDON, Sept 30 (Reuters) - While possibly Europe's biggest "pain trade", fund managers are under pressure to buy banking stocks despite the deep problems of Deutsche Bank and some other lenders in the region.
A 9 percent slump to record lows on Friday for the German lender was rapidly reversed in afternoon trade, exemplifying the difficulties investors face in staying bearish on a sector which still faces fundamental problems.
As the third quarter draws to a close, the main European banking index has rallied 19 percent from the start of July, with a number of constituent stocks rising sharply in contrast to those of some German and Italian banks.
This presents a dilemma for fund managers who, following a long period of poor overall performance by European banking shares, had taken heavily underweight positions in the sector.
With the index still down around a quarter this year, those who shifted towards other sectors have outperformed benchmark indices against which their funds are measured.
But now they find themselves in a tough spot. If the banking sector keeps rising overall, they risk losing these gains and underperforming for the full year - unless they raise the proportion of bank shares in their portfolio at least to neutral, matching the weightings in the benchmark indices.
According to strategists at Citi, European banks are the worst performing combination of business sector and geographical region among the 285 they have tracked over the past decade.
Acknowledging that buying into them now constitutes "the world's biggest contrarian trade", the analysts led by Jonathan Stubbs said in a note to clients: "History says Buy, but our key message is do not Underweight the sector."
GRAPHIC - Deutsche Bank's problems tmsnrt.rs/2dcqb49
Chasing the rally remains risky. The recent slump in shares of one of the region's largest lenders, Deutsche Bank , in the aftermath of a proposed fine by the U.S. Department of Justice has underlined the sector's longer-term problems, especially in the realms of regulation and financing.
Commerzbank will cut more than a fifth of its workforce and suspend its dividend while uncertainty about the clean-up of bad debts at Italian banks has also compounded long-standing worries over eroding profitability and rising regulatory costs.
Swiss investment banks are also struggling with negative interest rates. Credit Suisse says clients are sitting on record amounts of cash due to uncertainty in the global economy, leading to low levels of transactions and fee income. Chief Executive Tidjane Thiam said this week that banks are generally "a bit difficult to invest in".
Nevertheless, starved of returns and loathe to move into highly-valued sectors such as healthcare, investors have bought beaten-down shares - including in banks which suffered the biggest hits in a selloff that followed Britain's vote to leave the European Union on June 23.
Since the lows hit on July 6, French bank Natixis, ING Groep of the Netherlands and Scandinavian lenders such Nordea and Sydbank have all risen more than 25 percent. In Britain, shares of HSBC and Barclays are also up about a quarter.
The underperformers are dominated by Deutsche, the Swiss investment banks and a handful of Italian lenders - suggesting investors are discerning between the weaker and healthier banks rather than treating the sector as a single trade.
Deutsche's chief executive has told staff that the bank remains robust despite the demand for up to $14 billion from U.S. authorities for misselling mortgage-backed securities.
Bankers and policymakers are also playing down comparisons between the problems at Germany's largest lender and the collapse of U.S. investment bank Lehman Brothers in 2008 which sent shockwaves through global markets.
Nevertheless, investors cannot ignore the risk of contagion and that Deutsche's problems could spread to other banks that deal with it, should it slide deeper into crisis.
Still, signs of a possible subtle shift in monetary policies globally away from negative interest rates, prompted by a Bank of Japan policy overhaul last week, have raised hopes of a profit recovery for the banks.
This, combined with the multi-year low valuations and fund managers' heavily underweight positions, suggests there may be room for the rally to run longer, although many remain cautious.
"I'm not saying that it is now time to buy banks, I'm asking myself the question about whether it is time to buy banks," said Guy de Blonay, a portfolio manager specialising in financials at Jupiter Asset Management.
"I think valuations may be pricing in too much bad news, because the market was pricing a negative rate getting worse and worse as we went along," he said.
Blonay's Jupiter Financial Opportunities Fund had only two banks in the top 10 holdings at the end of August, Banque Cantonale Vaudoise of Switzerland and Copenhagen-based Danske Bank.
Fund managers who held a small portion of banks in their portfolios outperformed as the banking index fell steadily for a year from July 2015. But the turnaround of the past quarter has created a problem for those who largely shunned the sector.
"If you did that, you're now at risk of giving back all of that outperformance," said Edmund Shing, Global Head of Equity & Derivative Strategy at BNP Paribas.
The solution may be to buy at least some banking stocks. "At a certain point the pain becomes so great that those who have lost a bit of their outperformance now want to lock it in," he said.
In the Schroder ISF European Equity Alpha fund, for example, financials rose to just under a third of the portfolio at the end of August from roughly 26 percent at the end of April.
In a note to clients titled "Are Banks Europe's biggest pain trade?", Shing said analysts had started upgrading estimates on banks' return on equity and that the outlook for certain areas such as retail banking and mortgages is relatively healthier.
While Swiss investment banks like Credit Suisse and UBS have struggled, lenders focused on more traditional business such as HSBC, Standard Chartered and Swedbank are all comfortably up on the year.
Not everyone is convinced of a turnaround. While profits at U.S. banks are back above levels last seen before the financial crisis, those at European banks have halved since 2008.
"It's true valuations are very low. If you have growth, at some point shareholders will look again at banks but not until we see a decisive move away from a failed model," said Philipp Hildebrand, Vice Chairman at fund manager Blackrock.
Hildebrand, who was a Swiss National Bank policymaker during the global crisis, noted this week that the total return for bank shareholders since the 1990s had been zero. "That's a devastating number," he said. (Additional reporting by Anjuli Davies; Editing by Vikram Subhedar and David Stamp)