"I'm a rogue," Raj Rajaratnam, founder of the Galleon Group, memorably declared. He may have come to regret those words, caught on federal wiretaps and made public during Rajaratnam's recent insider trading trial, leading to his conviction.

While Rajaratnam may have been honest with himself about his lack of ethics, relatively few investors were aware of it. Instead, they were dazzled by his hedge fund's success in gaining an information edge, and turning that edge into megaprofits for both Galleon's leaders and its investors.

The problem? That edge was obtained by bribing or coercing Galleon employees and a network of outsiders into providing Rajaratnam with insider information on a host of companies, including such names as Advanced Micro Devices and Polycom. Especially desired was advance warning of outsize earnings. That information was the basis of much of the profits Rajaratnam and Galleon returned to investors.

"I remember sitting across the table from Raj at an introductory meeting organized by Goldman Sachs and wondering, how on earth does someone get it right so consistently, across a number of industries?" says Carter Furr, managing director of alternative investment strategies at Signature Financial Management in Norfolk, Va. "Very early on in the meeting, it was clear this was a non-starter for us, because we were cynical about these hyperactive trading strategies," he recalls. And yet, scores of other investors either ignored or never had such concerns; at its peak, Galleon had $7 billion in assets under management.

SIREN SONG

For financial advisors and their clients, the allure of hedge fund investing is unmistakable. At their best, these private pools of capital have extraordinary freedom to find gains.

In theory, a multi-strategy hedge fund could put startup capital into a Macao casino, develop a complex derivatives strategy based on European debt and place long-term bets on new tech companies - simultaneously. They face few restrictions, and are able to short securities or use leverage in hopes of maximizing returns.

Best of all, they offer advisors a way to diversify their portfolios beyond the stocks and bonds open to all investors. True, most hedge funds didn't generate positive returns in the firestorm of 2008, but they did again demonstrate that they weren't completely correlated.

On average, they provided more of a cushion: a study by finance expert Roger Ibbotson published early this year showed that hedge funds generated an average alpha of 3% annually from 1995 to 2009. No wonder investors are pushing their advisors to get them into hedge funds, and advisors are urging their clients to consider hedge funds as a way to diversify and boost returns.

INVESTIGATING PEOPLE

A problem, Furr says, is that it's hard for most advisors to undertake the level of due diligence required to figure out which hedge fund managers can genuinely add alpha, and which ones are breaking the law (like Galleon) or perhaps orchestrating a massive fraud (à la Bernie Madoff). "There's a lack of transparency in this industry, and the alignment of incentives can lead to bad behavior on the part of bad actors," he says. "I believe there are more [hedge] funds in existence than there should be, and that those that genuinely earn their fees consistently are a very small subset of the industry."

An entire industry has sprung up around the need to do due diligence on hedge fund managers and their strategies. Some of its members spend their time probing the background of managers, looking for any signs that they are willing to take excessive or unwarranted risks, or if any of their past history or anyone in their network of colleagues raises a red flag.

"We'd look at whether they are into racing cars, extreme sports or piloting experimental aircraft - and how much time they spend doing that instead of running the fund," says Tim Mohr, head of the hedge fund investigative due diligence practice at BDO Consulting in New York. An especially ugly divorce can eat into a manager's ability to concentrate on what's happening in the financial markets.

Yet another issue: "I'll look for people who might be related to each other in key positions within the fund and its advisors, like its auditor," Mohr explains.

INVESTIGATING STRATEGIES

Mohr doesn't scrutinize hedge funds' methodologies. That's the task of people like Neil Chelo, director of research at Benchmark Plus, a Tacoma, Wash.-based fund of hedge funds group.

Chelo helped whistleblower Harry Markopolos probe the Madoff fraud, and now spends his time ensuring that Benchmark investors don't end up in any other troubled or fraud-ridden funds. He also seeks out funds that genuinely add value.