Two of the most successful investors in financial services stocks are wildly bearish on the financial sector and that could be a strong sell signal.

David Ellison, a long-term financial services investor has increased the cash levels of his two mutual funds. At the end of June 2008, his FBR Large Cap Financial fund (FBRFX) was so liquid that it held nearly half of its assets in a short term U.S. treasuries.

The Paulson Partners hedge fund became widely known last year when it sextupled in value last year after shorting subprime mortgages. Paulson estimates that the financial meltdown is only a third of the way indicating plenty of room on the downside. Below are three financial services mutual funds with some of the worst performance so far this year and which may be good sale candidates.

Fund specifics
Kinetics Market Opportunities (KMKNX) seeks long-term growth of capital, but as recent performance has shown that is not always achieved. Kinetics top holding at the end of the first quarter of 2008 was State Street (NYSE:STT), but stocks that run the markets, such as the Chicago Merc (NASDAQ:CME), make up the majority its largest holdings. Active trading can bolster the returns for these stocks but if investors hunker down to wait out the storm their prospects could dim significantly.

Unlike the other funds, AIM Financial Services Inv (FSFSX) is domestically focused. Stocks with well known U.S. names like Citigroup (NYSE:C) and JP Morgan (NYSE:JPM) are this fund top holdings.

Fidelity Select Insurance (FSPCX) invests primarily in insurance companies, yet even a nearly 10% bet on Warren Buffet's Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) failed to save the fund from sinking to the lowest levels of its peer group. Fidelity Insurance also had the highest turnover of the three funds, which at 60% was well above the roughly 15% rate for the other two funds. In mid 2008, Brian Wilhelm, took over as portfolio manager for the fund marking him as the newest manager among the three funds.

Fund facts

Fund

Year-to-date Return

Net Expense Ratio

Total Assets as of 6/30/2008

KMKNX

(31%)

1.74%

$95 million

FSFSX

(28%)

1.31%

$278 million

FSPCX

(30%)

.93%

$109 million

Source: Morningstar.

Fund prospects and risks
In 2005, hedge fund manager Paulson began making bets that the ever-worsening credit crisis would significantly impact the financial services sector. That long-term perspective paid off handsomely as the mortgage meltdown has forced some of the world's biggest banks and securities firms to take nearly a $500 billion in asset write-offs and credit losses.

Another hedge fund managed by the Fortress Investment Group (NYSE:FIG), raised over $500 million dollars in the spring of 2008 to make a bet that the bottom of the mortgage market meltdown was near. Fortress bought triple-A-rated residential mortgage-backed securities and, despite losing over a third of their value within several months, another $200 million was added to the fund in June. Timing plays a critical role in performance, and as Fortress has demonstrated, if you invest too early a lot of money can disappear very quickly.

Even though financial stocks rose from their depths in late July that upward spike could simply be a dead cat bounce, followed by more negative returns. Mortgage foreclosures and stress from rising inflation and a slowing economy are likely to cast a pall over consumers for some time to come. Increased government involvement and regulation may keep some of the financial zombies alive while restricting innovations in this area.

Portfolio fit?
Financial services stocks have been beaten up and may have found a floor, but that may not be the case. It seems reasonable to expect significant short-term volatility in this sector, at least until the market sorts out an appropriate price level. If this is the beginning of a broad economic downturn, then it may be time to cut your losses in the financial sector and move on.

Related Foolishness: