The media has sought expert advice on avoidingthe next Bernard Madoff. (As this essay goes to press, that title seems to have been won by Robert Allen Stanford of Houston. The SEC alleges that he perpetrated an $8 billion fraud.) The irony is that the experts, usually financial intermediaries themselves, are part of the problem—they enabled Madoff's fraud. It's like asking gun manufacturers to opine on homicide abatement. The issue of advisors' lax due diligence has been deflected.

Suspicion is the job of financial intermediaries, not investors. Investors rely upon their consultants and fund-of-fund managers to scrutinize performance for potential fraud. Financial audits aren't designed to validate performance; they verify procedures and pricing. The best defense against fraud is a strong offense in the form of real due diligence. Hedge fund due diligence has been a fake, at least until now. The gun in Madoff's hands was advisors' complacency.

The Madoff malaise exposed our vulnerabilities: (1) We're too trusting; and (2) fraud viruses are spread by advisor and regulator complacency. It's time to protect our clients with a potent due diligence inoculation.

Due diligence can be distilled down to two crucial questions: Do we like the strategy that this manager employs? Does this manager execute the strategy well? Common hedge fund due diligence answers the first question with hot performance and accepts conceit and concealment as answers to the second. Madoff was enabled by this due diligence sham. Here is a two-step due diligence approach that is rigorous and sham-free.

Identify What the Manager Does

The adage "Don't invest in what you don't understand" is particularly relevant to hedge fund investing. To address this issue, we recommend that the researcher complete a fairly straightforward profile. Consider the following criteria:

• Approach long: Exposures to styles, sectors, countries, etc., as well as exposures to economic factors.
• Approach short: Exposures to styles, sectors, countries, etc., as well as exposures to economic factors.
• Direction: Amounts long and short
• Leverage
• Portfolio construction approach: Number of names, constraints, derivatives, etc.

In my practice, if we can't complete this profile, we don't invest. That's the deal. If we can complete this profile, we can move on to the question of manager competence. We want to know that value added exceeds fees. The traditional approaches to skill assessment are peer group and index comparisons, but these are unreliable markers. We need better skill-assessment approaches because hedge funds are unique.

Test Manager Competence Empirically

Performance evaluation ought to be viewed as a hypothesis test: Assess the hypothesis, "performance is good." To accept or reject this hypothesis, construct all the possible outcomes and see where actual performance falls. If the observed performance is toward the top of all of the possibilities, the hypothesis is correct, and performance is good. Otherwise, it is not. In other words, the hypothesis test compares what actually happened with what could have happened.

Using the profile described above, a computer simulation can randomly generate portfolios that comprise a custom peer group for evaluating a hedge fund's performance. A reported return outside the realm of possibilities is suspicious, and can be explained in one of three ways: The return is in fact extraordinary, the return is fraudulent or the strategy has not been followed. Of course the test itself cannot tell us which of the three possibilities is correct, but it does give us motive to look. In other words, the hypothesis test either validates the credibility of reported performance or provides the wherewithal to question the incredible. Financial audits are not designed to provide this validation.

Sociopathic fraudsters like Bernie Madoff are keen to capitalize on complacency. Hypothesis testing is a defense. It sets off fraud alerts that cannot be achieved with antiquated due diligence approaches, and so puts an end to the due diligence sham. Use it whether you're looking for Madoffs—or not.

Ron Surz is president and CEO of PPCA and a principal of Target Date Analytics and RCG Capital Partners, a fund of hedge funds.