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Managers are generally restricted to investing based on their prospectus.

True enough, but where does the prospectus come from? In the case of an index fund, clearly the fund has to follow the index. However other funds can certainly have a prospectus that allows a lot of cash and also hedging with options. Unfortunately, they do not, for the most part. One exception is "long-short" funds, but these have not performed very well, at least when I last looked at them.
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