Seeing in the Dark

The case of Bayou shows how difficult the vetting process can be. While there were some minor discrepancies in Israel's story (an allegedly exaggerated resume and links between a fund principal and its auditor), they were difficult to spot.

"This is a guy who had a family. His grandfather was a legend," says Ken Raisler, a lawyer who heads up the hedge fund practice at Sullivan & Cromwell. "The guy was well-known. He did not come off from under a rock."

Even a $7,500 fine paid by Bayou's broker dealer, Bayou Securities, to the Connecticut Banking Department didn't seem like a big deal, in and of itself. "They failed to keep records. It doesn't seem like [they're] engaged in a fraud," says Raisler.

McKee says that he had conversations with managers of 10 funds of funds who had been approached by Bayou and who declined to invest in the hedge fund. Interestingly, each of them cited performance for the demurral -- not concerns about the fund's integrity.

Whatever the reason, investors in those funds weren't exposed to Bayou -- an example of how the search for diversity can sometimes be protection from a host of sins.

"The ultimate protection is to invest in a diversified fund of funds. With no position greater than 3%-4%, you can't lose more than that," says Richard Leibovitch, a Boston-based partner at $5.5 billion fund of funds Gottex Fund Management.

Rich people have long relied on word-of-mouth when picking asset managers. While the method remains the only game in town among the rarefied air of hedge-fund stars, it is quickly losing its luster as the industry mushrooms.

"For individual investors, it's who they know, what their friends are doing," says one fund of funds executive. "I think they're crazy."