Seeing in the Dark

Who is responsible for the investor's money? Ultimately, the investor. But investing in hedge funds is usually done through a complex chain of players that may or may not have the investor's interest at heart. Hedge fund marketers, for instance, get paid by hedge funds to round up investors. Hedge fund consultants collect a fee from investors, but might have hidden incentives to drive them to a particular fund or group of funds.

Because hedge funds are so lightly regulated, an investor who runs into trouble has limited recourse. A marketer who fails to disclose a fee arrangement might be committing fraud, but because marketers are often not broker dealers, the NASD has no jurisdiction to enforce claims.

Much due diligence in the hedge fund industry is done by fund-of-funds managers whose task is to select a pool of good choices and invest their clients' assets in them, like mutual funds select the best stocks. Funds of funds usually have a team of analysts who screen managers and monitor performance.

Fund of funds researchers evaluate returns and make sure managers are in sync with the strategy they are supposed to employ (to prevent "style drift"). This kind of due diligence reportedly helped some investors get out of Bayou before the ship sailed.

Still, most sophisticated investors insist on much more than quantitative analysis. They want their representatives to act like detectives, checking the background of a manager, his work affiliation, his resume, former colleagues, court records, public documents -- even his private life. The investigation can go as far as checking the manager's relationship with his spouse and partners. In some shops, divorce is considered a red flag. Conflicts with employees or partners are warning signals.

"I know this is a biased, self-serving statement, but I don't think funds of funds are equipped to do people due diligence on their own," says Randy Shain, executive vice president of BackTrack Reports Group, an intelligence division of First Advantage and a company that specializes in conducting investigative work for several dozen funds of funds.