Banks come in from the cold for hedge funds

* Industry bets big on deregulation and interest rate rises

* Banks make up 5 of 50 stocks in hedge funds' top 10

* Investor (LSE: 0NC5.L - news) demand highest since 1999 - Blue Lion Research

By Maiya Keidan and Svea Herbst-Bayliss

LONDON/BOSTON, March 6 (Reuters) - Bank stocks are back in vogue for hedge funds, which have shunned the industry over the past seven years due to a squeeze on banks' profitability from low interest rates and because of their opaque balance sheets.

The election of U.S. President Donald Trump has already tempted some hedge funds back into bank stocks to raise their bets on deregulation and interest rate rises in the United (Shenzhen: 000925.SZ - news) States, which could help banks to earn higher returns on deposits.

"I think people are overweighting," Hilmi Unver, partner at hedge fund investor Notz Stucki Group, said. "Financials should benefit from interest rates going up." He also said Trump was pro deregulation, which would benefit U.S. banks.

Banks made up five of the 50 stocks most commonly in the top ten holdings of hedge funds at the start of 2017, the largest portion since 2013, data from Goldman Sachs (NYSE: GS-PB - news) showed.

Among the top five stocks were Bank of America Corp, JPMorgan Chase & Co (Xetra: 850628 - news) , Wells Fargo (Swiss: WFC-USD.SW - news) & Co, Citigroup (Swiss: C-USD.SW - news) and Citizens Financial Group.

Globally, institutional investor appetite for hedge funds buying bank stocks has risen in January to its highest level since 1999, estimated at 16.4 percent, up from 13.9 percent in December 2016, according to preliminary data from industry tracker Blue Lion Research.

Many managers favour U.S. banks stocks, but some hedge funds are also trickling into European banks even though some of these lenders are still dealing with fallout from the 2008 financial crisis and now face uncertainty from upcoming elections.

"European banks trade at almost half the valuation of U.S. banks and I think the political risk is overstated ... a lot of people are on the sidelines," said one London-based hedge fund manager who started adding European banks to his portfolio in January. "The big money will be made by buying these things now."

“One of our biggest long positions is Credit Suisse (IOB: 0QP5.IL - news) ," Lars Franstedt, chief investment officer and partner at $150 million Madrague Capital Partners, said. "We believe that it’s one of the best ways to play long in the financial industry."

Said Haidar, president and chief executive officer at $313 million Haidar Capital Management, which is long banks globally, also said European banks looked cheap.

Low and even negative interest rates in Europe have made it difficult for banks to generate profits on deposits, depressing their shares, which has kept many hedge funds away.

But banks' profits could improve now interest rates are on the rise in the United States and ultimately could rise in Europe too.

"In Europe, where banks trade at steep discounts to book (value), steeper curves, the coming end to quantitative easing followed by rate hikes in late 2018 or early 2019 should bolster results," Haidar said.

Wellington Management’s hedge fund Bay Pond Partners, a fund which focuses on the financial sector in general, has benefited from a strong move in bank stocks.

After losing 7.1 percent in 2016, the fund gained 6.4 percent in January, several people familiar with the fund’s performance said.

Representatives for the fund were not immediately available to comment.

U.S. hedge fund manager Dan Loeb shifted his focus to banks, he wrote in an investor letter on Wednesday, with the sector now making up 11.8 percent of his $15 billion fund, up from 4.4 percent on Nov. 8.

Before the financial crisis, many hedge funds reaped big rewards from a bull market in banks between 2005 and 2007. They then took short positions on banks between mid-2007 and 2009, betting on falling share prices. During this period, for example, Bank of America (Swiss: BAC-USD.SW - news) shares lost almost 75 percent of their value, according to Thomson Reuters (Dusseldorf: TOC.DU - news) data.

But after 2009, most funds stepped back from banks because of pressure on deposits from low interest rates. Some even shut up shop completely. Lansdowne Partners, one of London's oldest hedge funds, closed its financials fund last year, which had lost 18.7 percent in the first 40 days of 2016. (Reporting by Maiya Keidan, additional reporting by Lawrence White and Lawrence Delevingne. Editing by Jane Merriman)