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(Adds hedge fund manager comment in 17th paragraph)
* Top hedge funds ramped up financial holdings in Q2
* Buys of BofA, JPMorgan fueled "worst is over" bets
* Citi left out in Q2; Vinik buys gold (For other stories in this series on hedge fund activity in the second quarter, click on [ID:nN01502629])
By Al Yoon
NEW YORK, Sept 2 (Reuters) - At least 20 top hedge funds boosted their positions in financial institutions in the latest quarter in a sign that Wall Street is ready to bet on more risky sectors in the hope of longer-term rewards.
The push into financials indicates that fund managers including Steven Cohen and John Paulson, who are watched closely as barometers of risk, have shifted from routine merger arbitrage plays to directional bets that have more potential.
The aggressive switch was given credence by stress tests conducted by U.S. regulators that underscored the underlying health and viability of banks -- if they could raise capital.
Low stock prices also made banks a safer play, even if their profitability was still in question, said James McGlynn, manager of the Calvert Large Cap Value fund.
"It's a fundamental bet that they won't go to zero, and that liquidity will come into the system" over time, said McGlynn, whose fund owns shares in Bank of America(BAC.N) and JPMorgan (JPM.N). Big banks have "breathing room," he said.
Positions in big financials such as Bank of America and JPMorgan Chase stood out among the holdings of hedge funds in the second quarter, according to a Thomson Reuters analysis of regulatory filings.
The group of 30 hedge funds in the analysis increased their exposure to the financial sector by 56 percent to $59.5 billion in the second quarter compared to the first.
Filings showed at least five of the top funds bought into Bank of America, led by Paulson's purchase of 168 million shares. Shumway Capital Partners, run by Tiger Management alum Chris Shumway, bought 24.1 million shares and Timothy Barakett's Atticus Capital bought 26.9 million.
(Click on [ID:nN01234966] for details on top plays by hedge funds in the second quarter)
The investments in the financial sector speak to improving outlooks for the economy and expectations that organic growth should follow.
Hedge funds are probably looking for companies that are strong in traditional lending roles instead of former profit centers such as structured debt, said Nadia Papagiannis, an analyst at Morningstar in Chicago.
Government-engineered aid over the past year through the U.S. Treasury's Troubled Asset Relief Program and guarantees on unsecured debt also created backstops and tailwinds for banks.
A lasting rebound for bank profits is in question, however, as mortgage delinquencies and foreclosures are rising despite efforts to slow the trend.
Because nonperforming assets are still growing faster than bank reserves, profit growth probably will not emerge until 2011, veteran bank analyst Richard Bove said.
Also, estimates for rising stock prices have nearly been achieved.
Since lows struck in April, Bank of America's share price has risen 155 percent to $16.46, close to the $17.61 mean target estimate of 19 analysts.
JPMorgan shares are up 65 percent to $41.67, less than $3.00 short of 16 analysts' mean forecast.
"My guess is you won't see a lot of buying, but not a lot of selling either" by large hedge funds in the current quarter, said Whitney Tilson, founder of hedge fund T2 Partners LLC, who has bet on Wells Fargo & Co (WFC.N) over Bank of America. "They are in for more of a move than we've seen."
In addition, hedge funds like contrarian bets.
Paulson won big with his call against subprime mortgages in 2007, a success that continued with bets against banks entangled in risky loans.
Profits contributed to a quadrupling of assets under management in the two years through 2008 to $29 billion.
Hedge funds "have a very good understanding of (financials), having been involved in them throughout this cycle," said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago.
"Their view is probably that the worst is over for many of the financials."
Analysts cautioned that revelations in public filings probably do not tell the whole story.
For example, the 30 hedge funds included in the analysis dropped 44.8 million shares of Citigroup Inc (C.N), more than in any other company last quarter, the filings show.
While fears of fresh losses taint Citigroup, analysts have noted that some selling came as investors put on strategies to capitalize on the bank's plans to swap preferred shares into common stock.
To do that, investors bought preferred shares and sold short the common stock.
Paulson bought Citigroup stock in August, the New York Post reported last week, citing unnamed sources.
Other financial shares added by the funds included E*Trade Financial Corp (ETFC.O) -- dominated by Citadel Investment Group's 1,000 percent increase -- Regions Financial Corp (RF.N) and Fifth-Third Bancorp (FITB.O).
"Before, financials all moved together and now the distinction is who is strong," Calvert's McGlynn said.
The trend of increased hedge fund positions in financials was matched with gold for funds including Lone Pine Capital which boosted SPDR Golds by 803,500 shares to 3.45 million.
Vinik Asset Management, run by the former Fidelity Magellan Fund manager Jeff Vinik, made SPDR Gold shares its biggest holding with the purchase of 2.1 million shares.
SPDR Golds were also the biggest holding for Paulson.
For a list of the top 30 hedge funds, go to here
For a pie chart of the portfolio breakdown by sector, go to here
For a graph on the change in market value by sector, go to here (Additional reporting by Joseph Giannone; Editing by Kenneth Barry)