Hedge funds, red flags and colorblind investors

An October 7th panel discussion entitled, "Lessons From the Swamp -- What We Can Learn from the Bayou Debacle," attracted about 140 investors, regulators, academia and portfolio managers to the Yale School of Management last week. “There were ‘screaming red flags‘ that with proper due diligence investors could have picked up on,” said one panelist.

And it's likely investors will be fooled again, said Stuart Robinson, an FBI agent who supervises the white-collar investigative squad in Fairfield County.

"I'd like to propose to you that it is overwhelmingly likely that there are other Bayou's out there," he said. "Just because Bayou got caught, nothing has truly changed. It's an industry geared to very smart people that get in over their heads so they commit criminal acts. These are folks . . . who are geared toward reporting perfection in their professional lives."

For some managers who aren't realizing the results they want, "lying is the only way to earn a living the way they are accustomed to," Robinson said.

In fact, "the next Bayou" seemed to have emerged already. A few days earlier, Lehman Brothers charged a West Coast hedge-fund firm, Wood River Capital Management, with fraud. The SEC followed with charges that two of Wood River's funds had invested nearly two-thirds of their assets in one stock while promising clients diversified investments.

The stock, a tiny wireless venture called Endwave, repaid Wood River's faith by losing most of its value.

Yesterday's Wall Street Journal (subscribers only) commented:

As investors and securities firms assess possible losses related to the ailing hedge fund Wood River Partners LP, questions are growing about how sophisticated market participants overlooked a series of red flags surrounding the firm.

Investors, institutions and wealthy individuals, have been pouring money into hedge funds at a prodigous rate. Question is, how many wealth managers can match Yale's David Swensen in his ability to pick top-performing funds and avoid the disasters?

And even if you have a "second Swensen" on your team, hedge funds can be a dicey game for your clients. See The Guardian's cheery news item: World's hedge funds face crisis as Refco suspends trading.