WHILE many market analysts are decrying the current stock rally as being overblown and fundamentally unjustified, not everybody agrees. Data last week from Thomson Reuters revealed that at least 20 top hedge funds boosted their positions in financial institutions during the second quarter. <br /><br />The group of 30 hedge funds in the analysis increased their exposure to the financial sector by 56 per cent to $59.5bn in the second quarter compared to the first. On average, financials now make up 14.8 per cent of hedge funds’ portfolios.<br /><br />The data indicates that big hedge funds are now confident enough in the recovery to start taking directional bets on more risky sectors such as financials. Hedge funds have been particularly positive on Bank of America and JPMorgan, according to regulatory filings, which showed that at least five of the top funds bought into Bank of America led by John Paulson’s purchase of 168m shares. <br /><br />Financial equities, along with miners, have led the broader rally in global equity markets that we have experienced over the past six months and the hedge funds have clearly been making the most of renewed optimism on the sector. <br /><br />Joshua Raymond, market strategist at spread betting firm City Index, said that the reason that financials have led the equity rally is because they have had two very good earning seasons and a number of big banks outperformed earlier than analysts had expected.<br /><br />Raymond also notes that banks’ balance sheets are looking a lot healthier than they were six months ago, partly because of the impact of quantitative easing and the US support for banks. Stress tests have also contributed to the more positive outlook because they have reduced investors’ uncertainty about financial corporations. <br /><br />Equally important has been the banks’ decimated share prices. Citigroup plunged to $0.97 while on this side of the Atlantic, now part-nationalised RBS fell to as low as 10p back in January. Shares have recovered but they remain low and so investors benefit from limited downside. Relative to what they could earn, many banks are still looking relatively cheap buys.<br /><br />So given all this positive news, should spread betters also be making the most of the hedgies’ more upbeat outlook on the banking sector? If you are a spread better who likes to day trade or hold positions with a very short-term view, then there’s no reason why you shouldn’t. However, bear in mind that while hedge funds are very quick to react to positive news, they are just as quick when they hear negative news. Be prepared to exit your position and make sure your stops expose you only to a level of risk that you are happy with. <br /><br />While the hedge funds have been primarily buying into Wall Street banks, the globalised nature of the financial system means – as we know only too well – that what applies in the US will also apply to British banks. If you do want to take positions in the US banks, then Goldman Sachs is probably one of the safest bets there is, says Raymond. While it did not exit the crisis unscathed, it was in better shape than a number of its compatriots. <br /><br />The most risky plays – and certainly not for the faint-hearted – remain Citigroup, Bank of America, RBS and Lloyds, all of which still have very volatile share prices. <br /><br />That said, these stocks are much cheaper than their more robust counterparts and will be less costly for spread betters to add to their portfolios. <br /><br />With the market rally losing pace, spread betting provider Capital Spreads says that traders need to look hard for those stocks such as RBS and Lloyds which have not run out of steam. At the end of August, Capital Spreads’ clients held more long positions in RBS than any other stock.<br /><br />The hedge funds’ move in to the financial sector demonstrates just how strongly they must believe that the banking sector has seen off the worst. While a corrective pullback might stem the current rally, the fact that the banks plummeted so far means they have much further to rise. Provided there are no more big shocks, that is.