Hedge Funds Chasing S&P Index Summer Rally

Hedge funds, mutual funds, high-net worth individuals and sovereign wealth funds increased their net buying in equities for a seventh straight week to the highest level in 5 ½ weeks, according to internal client activity at UBS, one of the biggest wealth managers in the world.

"Both U.S. clients and foreign clients were net buyers of most U.S. sectors," wrote UBS Strategist Thomas Doerflinger in a report released today. “Only health care and industrials were net sold by U.S. clients."’

The S&P 500 is up 8 percent in July following an April –June swoon that pushed the benchmark into a deep correction. Concern about the Euro region collapsing under the weight of bad Greek and Spanish debt, signs of a sluggish U.S. consumer and a mystifying one-day plunge in the Dow all played a part in scaring investors away.

Better-than-expected earnings have fueled the turnaround this month, along with more clarity on the Euro situation following stress tests of the region’s financial institutions. Once that spark was lit, the UBS data shows investors have piled in, fearful of missing a summer rally.

The pressure is on for hedge funds and all large money managers to seek out returns with 2-year U.S. Treasury rates at a record low. Investors are turning to hedge funds for bigger returns in this low-return environment, pouring $9.5 billion into the industry in the second quarter despite their spotty track record during the credit crisis, according to Hedge Fund Research. The danger is that this environment creates a herd mentality, causing short and fast bubbles in different asset classes, but no lasting returns.

With the market stagnating as earnings results wind down, the summer rally could be over before August, according to some investors. A glance at the UBS data over time shows that the market does to peak when client inflows reach an inflection point.

"I’m constructive on the market right now,” said Steve Cortes, founder of research firm Veracruz LLC. “But once the closet indexers catch on, I’m out of there."

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John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team