As Einhorn and other big names struggle, these rising hedge fund stars were up 40% last year

• A new generation of under-the-radar hedge fund stars are soundly outperforming better-known managers such as David Einhorn and Bill Ackman.
• The common thread among some the best hedge fund performers is in-depth sector expertise.
• Joseph Edelman's Perceptive Life Sciences fund surged 43.1 percent last year, according to a source familiar with the returns.

Adam Jeffery | CNBC

Activist investors: David Einhorn (left) and Bill Ackman.

The torch is passed as the old hedge fund guard is losing its touch in the current market.

A new generation of under-the-radar hedge fund stars are soundly outperforming more experienced, better-known managers such as David Einhorn and Bill Ackman.

The common thread among some of the best hedge fund performers is in-depth sector expertise.

In a stock market where 5 out of the 6 most valuable companies in the S&P 500 are technology firms, it's more important than ever to be an expert on rapidly changing technology trends and consumer tastes.

Joseph Edelman's Perceptive Life Sciences fund surged 43.1 percent last year, according to a source familiar with the returns. In comparison, the S&P 500 rose 19 percent in 2017. The biotechnology specialist firm has $2.8 billion in assets.

Chris Goodney | Bloomberg | Getty Images

Joseph Edelman, chief executive officer of Perceptive Advisors LLC

Edelman explained why it is so important to have a deep understanding of the biotech sector to outperform the stock market.

"Our largest investment focus is on developmental-stage biotech companies, which requires both a strong scientific focus and knowledge base, as well as significant investment experience and a realistic appraisal of the chances of success," he told CNBC.

Edelman further revealed how his firm analyzes companies to find the next great idea.

"We look at whether the mechanism of action of the drug makes sense for the disease being treated, as well as existing clinical and pre-clinical data. We believe that our knowledge, experience and investment process allows us to identify the most promising opportunities and size our positions appropriately," he added.

In similar fashion, technology-focused fund manager Alex Sacerdote of Whale Rock Capital, a firm with $2.5 billion under management, generated a stunning 36.2 percent return in 2017, according to Absolute Return.

Sacerdote also emphasized the importance of sector expertise for investing success in a 2015 interview with Graham & Doddsville.

"It can be tricky to invest in the tech sector. There is constant change, brutal competition, price deflation and often high and 'bubble' like valuations," he said. "In the technology sector, it's important to be a specialist. … Finding that competitive advantage, understanding it, appreciating it before other people, and developing a more in-depth understanding of its strength are really important to us."

While sector specialists are thriving, famous generalist value hedge fund managers are sputtering.

Einhorn's Greenlight Capital fund returned a meager 1.6 percent in 2017, according to an investor letter. And Ackman's Pershing Square declined 4 percent last year, according to its website.

Part of the reason may be the rise of computerized trading. The quantitative-oriented funds could be taking the low-hanging, numbers-based valuation opportunities away.

Einhorn tried to explain that his fund's current underperformance was due to a temporary phase in the stock market.

"Despite it being a good year in the market, it was a challenging environment for our investment style," he wrote in a note to clients Tuesday. "We have a value orientation and we take comfort from the margin of safety afforded by the low valuations of our long investments … while we certainly don't believe value investing is dead, it is clearly out of favor at the moment."

Value investing may be out of favor, but it is clear the market is rewarding sector expertise.

Spokespersons for Whale Rock and Perceptive declined to comment on fund performance for this story.