While it was unclear as Worth went to press whether the fund was the victim of a market-related death spiral (such as those that laid low Long-Term Capital Management and Granite Partners) or outright fraud (akin to the recent KL Financial debacle in Palm Beach, Fla., or the collapse of Michael Berger’s Manhattan Investment Fund in 2000), evidence seemed to be pointing toward the latter.

Most funds that close (hundreds of them, out of the 8,000 or so in operation, shut their d1oors each year) do so because they fail as businesses. Usually, this means the hotshot traders who left the investment banks where they learned their craft forget to pay their rent or could not read a balance sheet or had no marketing acumen. It also occasionally means that they or someone they hire makes off with all the money. These business failures are not the only cause of death for hedge funds (many close because their managers fail to hit their annual return bogeys, and rather than having to hit them twice the following year, they return their capital, close their doors and reopen under another name). But they do account for a significant chunk.

While fraud-related business failures are, in themselves, pretty rare, they can attract more than their fair share of attention. Bayou is no exception. Allegations of self-dealing (the firm traded through its own brokerage) and misrepresentation (the founder’s CV allegedly belonged in the fiction aisle, as, apparently, did the firm’s representations about its accountants) combined with a nice serving of dime-novel pathos (“This is my suicide note and confession .” began a letter from the firm’s CFO) make it the media trifecta of hedge fund scandals. Pundits are coming out of the walls.

Full-time Job
One particularly interesting post-Bayou article appeared in the August 31 edition of the Wall Street Journal. It provided a checklist for hedge fund investors who wish to avoid future disasters. The author recommended (among other things) that these individuals call the manager’s college to check his credentials, verify the information in the fund’s marketing materials, pay several visits over at least six months to the firm’s headquarters to meet with the managers, and scrutinize how the firm prices its securities.

For those with nothing else to do with their time, spending the better part of the waking hours of six months investigating a $5 million investment might make sense. These individuals will unfortunately have to restrict their attention to the worst-performing funds, where the managers are unable to attract money the way most of their better-performing peers do—by answering the phones—and who are therefore willing to spend time away from the trading floor wooing prospective suckers. But those who want to diversify their hedge fund holdings among a sensible number of well-performing funds while pursuing, say, a life might find this type of advice less than entirely useful.

Private investors have several avenues into the hedge fund world, including direct investing, but this is in many cases the least rational. The concentration risk, for one thing, is toxic. A private investor with a $200 million portfolio might want to have 20 percent of it allocated to alternatives—10 percent of the total to hedge funds, for example. That’s $20 million. With $5 million minimums, that’s four funds—far below an optimal number for diversification. Someone with $50 million to allocate to hedge funds can invest in 10 funds, providing a more reasonable level of diversification. But now consider the time and effort required to conduct due diligence and oversight on 10 funds.

Hedge funds of funds, which sadly have less cachet at the Maidstone Club bar, spread risk and have far more due diligence and oversight firepower than any single investor can muster. For those who insist on picking individual funds, many of the major wealth advisory firms provide pre-vetted lists of third-party managers; picking one of these tends to be far safer than going it alone. In any case, few hedge fund investors will be able to entirely avoid the Bayous of this world. But it is best to have at least one foot on firm ground when venturing into a marsh.