Fund managers that bet on a volatile, wild year of losses in the euro are paring back positions against the single currency going into 2012 after its surprising resilience to Europe's sovereign debt crisis damaged their portfolios.

Many still expect market turmoil arising from Europe's debt situation and have kept options strategies that will benefit from volatility. But they have put on trades that will pay off as well if the euro zone recovers from the crisis.

While Europe's debt drama kept markets on edge for most of the year, the euro is only down 2.6 percent against the dollar in 2011.

That is not as bad as headlines from the crisis might have suggested. This slashed returns for investors who paid premiums for strategies aimed at capitalizing on a sharp fall.

"Our mistake this year, especially in the first half, was looking a lot at headlines in the euro zone and trying to read the politicians' complete nonsense," said Harald Hild, portfolio manager at FX fund of funds Quaesta Capital in Zurich, Switzerland.

Hild runs the FX Volatility fund under the Quaesta group, with assets under management of about $3 billion.

"For most of the year, we were in a risk-off mode and we were paying high premiums for downside strikes in the euro and nothing really happened. So we started to look at it from a different perspective."

Investors generally pay for downside strikes, or lower exchange rates, when they believe the currency is going down.

Hild said the fund still expects the euro to go lower in 2012, but he'd rather hedge this view using calendar spreads, which involve entering a long and short position on volatility -- a measure of a currency's moves in either direction -- but with different tenors.

This strategy essentially plays on expectations of where volatility is headed over, say, a one-year period. If an investor expects euro/dollar volatility in the short term, but sees subdued price movement in 12 months, then he goes long one-month volatility and sells one-year volatility.

So far, Quaesta's volatility program has recovered, albeit slowly. The volatility fund was up 2.2 percent in November and 1.9 percent firmer so far this year in a performance that Hild describes as "disappointing".

WRONG-FOOTED

What appears to have wrong-footed investors betting against the euro in 2011 was that European banks sold assets abroad to bring funds back home to cushion against troubles in the European financial sector. This repatriation process provided unexpected support to the euro.

Particularly in October, currency managers were caught on the wrong side of the trade as stocks and commodities rallied and the euro gained 3.5 percent.

The Parker FX index, which tracks currency managers, was down 1.3 percent in October alone and 3.11 percent lower this year until the end of that month.

Despite a slew of negative headlines this year, ranging from wrangling within the euro zone to the latest warnings of downgrades from ratings agencies, the euro has held up relatively well.

The euro had a far more dismal year in 2010 when it dropped 6.6 percent and in 2008 when it posted losses of 4.2 percent.

Implied volatility on euro/dollar, or a broad measure of uncertainty in the options markets, has also remained subdued in recent sessions relative to the VIX index .VIX, the stock market's fear gauge, and gold's implied volatility .GVZ. There is anxiety in the currency options market about Europe's debt situation, but the tension has come down a lot.

Volatility, however, could ramp up again in 2012, with six European Union summits next year, two more than normal, on top of a host of extra Eurogroup events and meetings of finance ministers as they try to hammer out a comprehensive solution to the crisis. These events, for the most part, have been a major source of uncertainty for financial markets this year and that's unlikely to change in 2012.

SMALLER POSITIONS

London-based hedge fund GLC Ltd, with assets under management of about $1 billion, believes much of the mayhem in Europe has already been discounted and markets are not well-positioned for positive news.

As a hedge against the market's volatility, the fund has been running smaller positions than normal.

Even though GLC has been disenchanted with the way European leaders have handled the crisis, it believes the euro will survive and the situation in Europe's debt markets will improve, though in a volatile manner.

"Europe's policymakers, however, have left it too late to avert recession and much of the rest of the world is also suffering from an economic slowdown," said GLC in its latest note to clients and investors.

MARKET TURMOIL

FX Concepts, one of the largest currency hedge funds with assets under management of $4.3 billion, is still long volatility, calling for a U.S. recession and a breakup of the euro zone. But as a hedge to the firm's bleak view of the economy, "we have introduced models that have actually a positive tail," said Ron DiRusso, managing director of FX Concepts' Volatility Fund.

Positive tails suggest an upbeat outcome arising from either a resolution of Europe's debt crisis, or a more brisk pace of the U.S. economic recovery.

"So even in periods where mood is risk-on, or if the carry trade comes back, we have parts of the program that would make money in that environment," DiRusso said.

In several interviews with Reuters, FX Concepts chairman and chief investment officer John Taylor had painted a gloomy scenario for the global economy -- one in which the S&P 500 would precipitously drop to below 1,000 points and the euro would slide to parity against the dollar.

However, there were several months in the year, particularly October, when volatility declined and most risk markets and currencies such as the euro, Australian dollar, and emerging markets recovered.

FX Concepts' Volatility Program was down -0.88 percent so far this month and 5.85 percent weaker this year. The firm's Global Currency Program was down more than 19 percent as of December 22.

Bottomline, most fund managers are taking an "either-or" approach -- either the euro zone breaks up or everything is fine and well. And as the year winds down, more and more managers are looking at the latter scenario.

"Europe is not finished. We're not talking about Zimbabwe here. The euro is not a currency that will suddenly become worthless," said Simon Smollett, senior currency options strategist, at Credit Agricole in London.

(Editing by Andrew Hay)

• A Permanent Economic Emergency