Financial stocks are still top bets among some of the largest hedge funds, which continued piling into big banks like JPMorgan Chase & Co and Citigroup Inc in the third quarter.

Yet the hedge-fund managers, including billionaire investor John Paulson, scaled back positions in Bank of America Corp BNK.N as it was roiled by intense scrutiny over its acquisition a year earlier of Merrill Lynch.

The 30 hedge funds with the largest investment in stocks trimmed their holdings in Bank of America shares by 20 percent in the third quarter, according to a Thomson Reuters analysis of regulatory filings.

Just as the quarter ended, on September 30, Bank of America Chief Executive Ken Lewis announced he would resign at year-end. The bank has suffered massive credit losses and received two government bailouts amidst the end of the real estate bubble.

Paulson's latest quarterly filing showed he owned 159,794,229 common shares of Bank of America, down from 167,990,464 shares. Still, Paulson, whose bets are carefully watched by other managers, recently told clients in a letter that Bank of America shares can double in the next two years.

Paulson said BofA shares, which posted returns of nearly 30 percent in the third quarter alone, could rise to $29.81 by the end of next year, people who have seen his letter said. BofA shares closed up 11 cents at $15.76 on Thursday.

Overall, hedge funds retained big bets on financial stocks as they made Citigroup the biggest recipient of increases to existing positions. Paulson bought into Citigroup in the third quarter with a hefty 300 million share stake.

Other banks among the top 10 increases to existing positions included JPMorgan, Citizens Republic Bancorp Inc (CRBC.O) and Huntington Bancshares Inc (HBAN.O).

Hedge funds have been exposed to the banking sector because of its potential upside after financials were at the epicenter of the credit crunch and suffered the most during the bear market.

If you want an economically sensitive vehicle, there's none better, said Anton Schutz, president of Mendon Capital Advisors Corp, an adviser to funds with financial assets.

And if you believe that there's a recovery coming ... I think there's a reasonably good reason why people are here, Schutz said.

The scrutiny of Bank of America may have frayed nerves over the summer yet interest in the company can be seen by the large stakes investors still hold and their reaction to plans announced on Wednesday to repay its $45 billion bailout.

Shares shot up as much as 6 percent on Thursday before most of those gains were pared.

Bank of America unfortunately is stuck in neutral until they figure out who the CEO of this company is going to be, Schutz said.

Hedge funds also dumped stakes in troubled lenders Fannie Mae (FNM.N), Freddie Mac (FRE.N) and CIT Group Inc (CITGQ.PK) during the quarter, selling off more than 90 percent of their positions in the three companies.

Suncor Energy Inc (SU.N), whose acquisition of Petro-Canada made it Canada's largest energy company, and Emdeon Inc (EM.N) were the two biggest and most widely held new holdings among the 30 hedge funds. Emdeon, a medical billing systems provider, completed an initial public offering in August.

The most widely held stock among the equity holdings of 30 large hedge funds Reuters examined was MasterCard Inc (MA.N), yet few held major stakes in the credit card network.

Rival credit card network Visa Inc (V.N) was also among the five most widely held stocks. Both companies, which deliver steady revenue streams and do not carry the credit liabilities of card holders, have been among the most widely held stocks since at least late 2008.

Rounding out the top five most widely held stocks were Qualcomm Inc (QCOM.O), JPMorgan and Bank of America. The two banks were also the second- and third-largest overall positions held among the hedge funds.

The largest holding overall was Sears Holdings Corp (SHLD.O), bolstered by Eddie Lampert's huge stake. Lampert's holdings in ESL Investments Inc usually remain little changed quarter to quarter, although he sold about 40 percent of his stake in Genworth Financial Inc (GNW.N) during the quarter.

Lampert's long-term outlook on his holdings is more common than the rapid-fire trading strategies of D.E. Shaw & Co and Renaissance Technologies. While D.E. Shaw, Renaissance and Citadel Investment Group hold thousands of stocks each, half of the 30 funds under review held less than 100 shares.

The vast majority of hedge fund investors have a more fundamental as opposed to quantitative, high-frequency trading basis, said Bill Crerend, president and chief executive of fund of funds manager EACM Advisors LLC, a unit of Bank of New York Mellon Corp (BK.N).

Clearly hedge funds are at large more active traders than the traditional long-only world, Crerend said.

But people would be surprised at the intensity of fundamental work and the holding periods of hedge funds when you look at hedge funds broadly, he said. Those holding periods would be much longer than people might anticipate.

For a list of the top U.S. hedge funds by their equity assets under management, go to here

For a glance at major hedge funds and their holdings, go to here

For a graph of the portfolio breakdown by sector, go to here

(Reporting by Herbert Lash, editing by Matthew Lewis)

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