Seeing in the Dark

Funny thing about hedge funds. Sometimes the more forthcoming a manager is, the less you want to trust him.

Connecticut's embattled Bayou Fund doesn't currently rank as a bastion of transparency, but it did once. Bayou manager Samuel Israel was famously gregarious, showering investors with information, emailing weekly performance reports and telling anyone who would listen how great he was doing. Israel trumpeted annual returns that supposedly blew away most of his peers.

Now, the shades are pulled, and Israel has shut his mouth. State and federal prosecutors are investigating what happened to up to more than $400 million of client assets that some investors worry went up in smoke.

Don't trust appearances. Most hedge funds take the maxim to absurd lengths by giving virtually no appearance to trust. While they may give occasional valuation updates (monthly, quarterly, yearly), they are under no obligation to explain their trades or to disclose their underlying positions.

In short, most hedge funds are opaque -- and that's how clients prefer it.

"The hedge fund that are good don't want to bother with transparency," says Jim McKee, a consultant at Callan Associates who advises investors on managers out of San Francisco. Good managers believe disclosure erodes returns by tipping their hand or orienting performance to short-term goals.

Top managers tell their clients, "Trust me, the less you know about your investment, the better your returns will be." In a world where the best funds become closed to new investment almost immediately, it's a covenant that usually must be accepted.

So how are investors supposed to pick winners among the 8,000 hedge funds out there? When return is a direct function of talent and strategy, the question is an important one. Too much emphasis on a manager can leave you in unsuitable strategies or undiversified, while too little can lead to poor performance or worse.