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

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NEW YORK (–A report authored by Vadim Zlotnikov of Bernstein Research concluded that hedge funds will have a great continuing effect upon the rest of the asset management world. But this effect might not be found where many expect–whether they’re looking with hope or alarm.

The June 2003 report, “The Hedge Fund Industry: Products, Services or Capabilities?” said that hedge funds would not be a direct competitive threat to the rest of the asset-management industry. Most hedge fund categories show a pattern of returns similar to that of straddle options or collar options to the Standard & Poor’s 500 stock index, with significant downside protection but also somewhat limited upside potential, which is not a performance in itself sufficient to set the world aflame.

It found much more significance in the “service propositions and the … capabilities underlying their current products than [in] current product offerings themselves.”

Mr. Zlotnikov acknowledged the critical role of Guillermo MacLean in researching, structuring and preparing the 75-page report. Defining hedge funds as private investment vehicles not registered with the Securities and Exchange Commission and available to accredited or qualified investors, Messrs. Zlotnikov and MacLean distinguish four views of the underlying value of such funds:

1.A high service level to ultra-high-net-worth and high-net-worth clients;

2.Redefinition of traditional relationships or contractual terms between clients and portfolio managers;

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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