They are taking the view that the rally in financial markets over much of the past year, fuelled by central bank money printing, could mask a failure to tackle some European countries' and banks' debt problems, and the sell-off of recent weeks may be the start of a longer downward move.

"(A Cyprus-style bailout) will probably happen somewhere in Europe again," said Galia Velimukhametova, fund manager at GLG, part of hedge fund manager Man Group, at the GAIM conference in Monaco on Tuesday.

Cyprus was bailed out by the EU and the International Monetary Fund earlier this year, with some depositors having to take losses.

"Germany is going to have to spend more than 10 percent of its GDP to support transfer union ... They may ask for concessions - a haircut for debt, deposit measures to contain a capital flight," Velimukhametova said.

Bond markets, particularly in peripheral countries such as Italy and Spain that had been facing rising borrowing costs, rallied sharply after European Central Bank head Mario Draghi's pledge last July to do "whatever it takes" to protect the euro zone from collapse.

However, Velimukhametova said domestically-focused banks in some southern European markets could suffer as loan problems re-emerge.

"Our best investment idea would be (to) short domestic financials of peripheral European countries," she said. "There is a real asset quality problem in those financial institutions.

"We've done a lot of analysis. Non-performing debt ... in Italy is high teens, in Spain is high single-digits or low double-digits. However, usually after the audit, these things double or triple."

Other managers are similarly cautious.

"The European crisis is far from being over," said Philippe Gougenheim, CEO of Swiss-based Gougenheim Investments, who has gone short French government bonds against German bonds and is short the euro against the dollar.

"Deficits in Spain and France are worse than expected, growth is still negative in several countries and unemployment is reaching record levels. This trend is not sustainable and we expect a bumpy road for European markets."

Sushil Wadhwani, CEO of Wadhwani Asset Management and a former member of the Bank of England's Monetary Policy Committee, said some politicians had been "lulled into a false sense of security" by the ECB's bond-buying promises and had shown "no signs whatsoever" of making structural reforms.

MOST WORRIED

However, Wadhwani said he was most worried over the next two to three years about Japan, which in April pledged to inject about $1.4 trillion into its flagging economy in an effort to end two decades of stagnation.

The move, coupled with stimulus efforts by Japanese prime minister Shinzo Abe, sent stocks rallying and the yen tumbling and proved a much-needed boost for struggling managers of macro-economy-oriented funds.

One trader at a multi-billion dollar hedge fund, speaking on condition of anonymity, told Reuters the trade had proved "tremendous" for his firm and for many others.

However, Wadhwani said the Bank of Japan could be forced by politicians to buy "a lot more JGBs (Japanese government bonds) than is optimal in terms of its inflation target".

"You could get debt monetisation, which would meaningfully destabilise global markets and make the exit process (from central bank stimulus) problematic globally."

He said his favourite trade over the next 12 months would be shorting JGBs and U.S. Treasuries.

Another manager, speaking on condition of anonymity because the views were personal, was looking for investments that either won't suffer or will profit if equities fall.

"Is it just a shock that we've had, or the prelude to an eruption, in which case we're in very dangerous territory," the manager said.

"If Japan's revival doesn't materialise, then that could be the moment when people start to question their basic trust in the system and in countries' status as lender of last resort.

"People may start to question how are we ever going to get out of government indebtedness." (Editing by Greg Mahlich and David Holmes)

By Laurence Fletcher