July 28 (Bloomberg) -- Hedge funds may post their worst month in at least five years after bets on financial stocks and crude oil backfired.

Hedge Fund Research Inc.'s Global Hedge Fund Index of more than 55 funds slid 3.2 percent through July 24, heading for the biggest monthly drop since the measure started in 2003.

Wagers on a decline in financial stocks and homebuilders, one of the most popular, soured after Fannie Mae and Freddie Mac shares more than doubled in the six trading days to July 23. Bullish bets on crude oil turned to a loss as oil slid 15 percent from a record $145.29 a barrel on July 3 after doubling in a year.

``You have to believe that everyone had the same trade on,'' said Paul Meader, co-managing director of Corazon Capital Management, a Guernsey, Channel Islands-based manager with about $1.2 billion, mostly invested in hedge funds. ``There will be a lot of people hurting and licking their wounds with a tough July to report to their clients.''

Short selling of Fannie Mae and Freddie Mac jumped in the first two weeks of July as the stocks fell on concern that shareholders would be wiped out even if the government bailed out the entities. Instead, the shares doubled in six trading days, catching out investors who shorted the stock, selling borrowed shares in anticipation of buying them back at a cheaper price.

`Short Squeeze'

Short interest on McLean, Virginia-based Freddie Mac rose 28 percent to 105.9 million shares between June 30 and July 15, according to data compiled by Bloomberg. Short interest on Washington-based Fannie Mae as of July 15 was 154.4 million shares, up 11 percent from the previous month.

``Everything that went up was the most shorted,'' said Christopher Watling, head of Longview Economics, an independent London-based research firm. ``It was a classic short squeeze, a race to cover shorts, not buying because fundamentals had changed. It was a true sucker's rally.''

Some of the most-shorted European stocks, mortgage lenders and homebuilders in the U.K., also soared. HBOS Plc, Britain's biggest mortgage lender, climbed 17 percent on July 23, the most in six years, amid speculation that it could be purchased. Homebuilder Barratt Developments Plc more than doubled in three weeks, while rival Taylor Wimpey Plc almost doubled in 11 trading days.

``There's little doubt it was difficult,'' said Simon Cawkwell, a former accountant and investor who wrote ``Evil's Good,'' a guide to short-selling. ``The banks soared, all the associated stocks and the homebuilders. It caught a lot of people out. It caught me out.''

`Crowded Trade'

Another popular trade that backfired was shorting Volkswagen AG while buying its preferred shares. Many hedge funds and Wall Street proprietary trading desks bet that the difference between the two would narrow as investors realized the voting rights may not be worth a premium as Porsche SE increases its control. Instead, the difference between the shares widened to the most in 15 years.

``This has been a very popular and crowded share-class trade,'' said Renaud Berenguier, a hedge-fund adviser at Aurel Leven SA in Paris.

The short interest in Volkswagen, Europe's largest car maker, has almost doubled in the past month. About $10.5 billion was betting on a drop in the share price on July 22, according to Data Explorers, a London-based research firm that analyzes shares-on-loan data.

Still, Cawkwell, who has traded for more than four decades, said last week's reversals were ``par for the course.''

The gains that will be made after U.K. stocks hit a bottom, which are still ``far off,'' may be treacherous for short investors, as they were in early 1975, he said.

``Some of these stocks will advance very sharply indeed. In a week one could see 100 percent advances,'' said Cawkwell. ``This can happen, I promise you it can. Suddenly the whole thing turns around.''

To contact the reporter on this story: Tom Cahill in London at tcahill@bloomberg.net

Last Updated: July 28, 2008 05:52 EDT