Bernstein: Don't Look for 'Stars,' Look for Flexib

3.Specialization of innovative trading strategies and sophisticated financial tools;

4.Individuals with unique knowledge of an exploitable market inefficiency.

The report concludes that the second of those value propositions is the most promising, and the fourth is the least. Some investors are in search of a genius portfolio manager, a star, but they’re pursuing a risky course. The report even speaks of the image of star individual portfolio managers as one of “mysticism” induced by the complexity that surrounds volatility trading or derivatives plays.

The second of those propositions, though, stands out as non-mystical common sense. Over a period of time, both clients and consultants have placed a lot of restraints on traditional long-only managers, allowing them to select industries and stocks only within very well-defined benchmarks and tracking errors. “It seems as if hedge funds … are receiving more freedom or discretion from clients in exchange for a different incentive structure that is perceived to be better aligned with their clients’. Clients seem to be increasingly receptive to this model” which will exert its influence upon most of the active management world, through contagion and institutional synthesis.

The authors also take a fairly optimistic view of the results of ongoing regulatory scrutiny of the hedge fund industry. They write that regulation of sales and marketing practice “may be a catalyst rather than a deterrent” because it could demystify the industry in the minds of the public, opening new market segments. They acknowledge, though, that smaller funds would be hurt by the increased administrative costs due to regulatory requirements, and many will exit the market.

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