NEW YORK - Hedge funds are notorious for being secretive, private investment pools, but the time has finally come for them to become more transparent in order to capture the billions of dollars floating around alpha-seeking institutional investors' pockets.

Here's the key question: Assume you are a qualified investor with at least $1 million in assets. How do you conduct due diligence to find out what you're buying?

Dark Rooms, Secret Handshakes

"I remember when hedge fund conferences weren't held in nice hotels like this," said Lester Wigler, a financial adviser for Citi Smith Barney, standing under a brightly lit chandelier at the Helmsley hotel during a two-day "Hedge Funds 101 & 102" conference sponsored by Financial Research Associates. "They were held in dark rooms where you couldn't get in without a secret handshake, and even then, you didn't really know what the fund managers were talking about."

Some of the strategies that people were trying to keep secret have, in fact, produced returns that are above market averages, Wigler said, but not every millionaire or institution is willing to blindly trust a stranger with their money.

"If a manager is not giving you any transparency, that should be a red flag," said Constance Hunter, managing member of Coronat Asset Management LLP.

"There's no reason why you can't know exactly where every dollar is," echoed Bernard Gross, a portfolio manager at BG Capital Management LLC.

Managers who prefer to remain secretive may miss out on opportunities for larger clients. If you are confident about your strategy, Wigler told audience members, you should have nothing to hide. The worst that could happen is that someone could copy your strategy, but that's only a snapshot in time. They won't be able to predict your future decisions, he said.

Secrecy breeds suspicion, and several high-profile scandals in the hedge fund world have only increased investors' paranoia. Just last week, for instance, investigators said they now believe Samuel Israel III of the failed $450 million Bayou Capital faked a suicide jump over the Bear Mountain Bridge in order to sidestep a 20-year prison sentence. Israel is only one of a number of shady characters who've been making headlines, shocking colleagues and the investing public alike.

"Investors are afraid of a big blowup or a dire event that makes the front page of The Wall Street Journal," said Christopher Rae, managing director of Stamford, Conn.-based Chilton Investment Company. "Whenever a hedge fund makes it to the cover of The Wall Street Journal, it's almost always bad news."

Hedge funds close all the time for business-related reasons, Rae said.

"Every major blow-out was caused because the back office couldn't handle what the front office was doing," he said. "That's where due diligence comes in."

"Because it's an unregulated sector, there are instances of abuse," agreed Rakesh Bhargava, chairman of Blue Spruce Global Advisors LLC, based in Franklin Lakes, N.J. "You've got to do due diligence, both qualitative and quantitative. The person running the fund has to be someone you can trust. Look at the manager's background."

Most institutional investors draw the line at hedge funds with at least $100 million in assets under management, and half of them won't invest with a fund if it's a start-up, said Timothy Cunningham, president of the Philadelphia-based, financial services intermediary boutique Touchstone Group, LLC.

"They want to see tenure-firms that are three years old or more-with at least 36 data points," Cunningham said. "Otherwise, they won't buy it."

Due diligence is particularly difficult when a hedge fund has few employees and no website, but there are ways to use search engines and databases to find out what others have said about the company. Investment firms looking for portable alpha from hedge funds need to become part private detective to figure out what's really going on.

Body Language

Jason Gold, CEO of New York-based Aurarian Capital Management, said he regularly interviews portfolio managers his firm is considering, and he has worked out a system to deduce whether the fund's claims are true.

Short of bringing a lie detector to meetings, Gold said people's body language can be much more revealing than they realize. When he first meets with a prospective manager in person, Gold said he likes to start out with some small talk to see how they behave normally, and then looks for changes when he starts asking difficult questions.

He recalled a meeting where the people were acting normally during the small talk, but when he started asking tough, direct questions, one person kept taking sips from an empty Coke can and the other person started taking their shoes on and off.

"People say a lot of great things about themselves and their fund, but how do you know any of it is true?" he asked. "I highly recommend you visit a fund in person, if you get a chance. Onsite due diligence can save you millions."

Important things to consider are whether the office location is appropriate for their business, whether they have prior qualifications in the industry, how their fund separates itself from the pack and whether they can answer questions in a clear and simple manner.

"No hedge fund is too big to answer investors' questions," Gold said. "Ask them to provide examples. Hedge fund managers should not be stumped by your questions.

"Lastly, ask them how they handle the black swans. No one has prepared for everything. How do they handle the unexpected?"

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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