Hedge fund investors reminded of dangers

NEW YORK - Hedge fund implosions have become somewhat routine. Suddenly, the upbeat financial reports and bullish calls promoting stellar returns disappear, all correspondence stops, and the money is gone from investors' reach.

The latest example of this comes with the collapse of Bayou Group, once a high-flying Connecticut hedge fund with $400 million under management that went belly up last month. Now, the company and its founders are under investigation for fraud by state and federal authorities.

It's not that Bayou's situation is so unique; neither are the lessons that should be learned from its demise. Yet, it still serves as a timely reminder for investors about the dangers of hedge funds and how potential trouble can be sniffed out.

While bad behavior presumably isn't endemic to the largely unregulated hedge-fund business, it can't be forgotten that many funds strive for superiors returns than the broader market by employing risky trading strategies, such as arbitrage, shorting stocks and betting on the movement of commodities futures.

For those investors willing to take the risk, there can be big rewards - or big losses.

Clearly, those making such bets appear to be on the rise. In 1990, there were 610 hedge funds with about $39 billion in assets. Today, that has grown to nearly 8,000 funds with a total asset base topping $1 trillion, according to the Chicago-based research firm Hedge Fund Research Inc.

That growth has been largely fueled by increased interest from groups such as corporate and public pension funds as well as endowments and charities. Millions of Americans now have a stake in the game, not just the wealthy individual investors who had long served as the backbone to the hedge-fund business.

By putting money into hedge funds, this new crop of investors hopes to juice up their investment returns, which have been hit hard by low interest rates and what many consider a mediocre performance in stock market since the dot-com boom ended five years ago.

But Bayou's recent collapse highlights the pitfalls of hedge fund investing - sometimes things aren't as good as they look.

From afar, Stamford, Conn.-based Bayou appeared like a respectable place to invest. It claimed to have $411 million under management at the end of the last year. Bayou officials touted their solid trading and portfolio management experience, were accessible to investors big and small and provided regular updates on the fund's stellar performance.

A much different reality is now emerging. The company's founder, Samuel Israel, and other top executives went into hiding this summer as accusations of massive fund fraud mounted against them. Israel could not be reached for comment, and his lawyers in an Arizona case withdrew their representation of him.

Federal prosecutors allege that from 1998 through August 2005, Bayou "overstated gains, understated losses, and reported gains where there were losses." They are trying to freeze all Bayou assets, including $100 million that authorities in Arizona have seized.

That has left its investors scrambling to get their money back. Among them: the Jewish Federation of Metropolitan Chicago, a non-profit group that sued Bayou earlier this month because it has been unable to recover the $4 million it invested last year.

According to its lawsuit, Bayou claimed that its funds posted a 12.8 percent return in 2004, compared with a 9 percent gain in the Standard & Poor's 500 index, and told the federation that its investment had grown to more than $4.5 million over the course of the year. And while Bayou did inform the federation in July that it was closing, it never returned any of its money as it had promised.

Surely, plenty of Bayou investors are now wondering what they could have done to prevent getting tangled in such a mess. Too bad that some of the red flags are a lot more visible in hindsight.

For one, the company claimed that it used an independent auditor, yet the firm was founded by Bayou's chief financial officer. In addition, prosecutors allege that it was really a "sham" accounting firm that conducted "no audits, independent or otherwise."

Bayou used its own brokerage unit to execute its trades, meaning that it profited on all the trading that the hedge fund did and had control over how securities were priced. Using a third party to handle such transactions is considered safer.

Investors could have also checked up on Israel's experience. While he had claimed to have been the head trader at the prominent money-management firm Omega Advisors Inc., Omega has said that wasn't his role during his short tenure there.

The Securities and Exchange Commission is expected to implement new rules next year that will open hedge fund firms' books up to regulators and make the funds subject to regular audits and inspection.

Still, Bayou's collapse should remind investors that the best way to ward off potential trouble is to perform thorough due diligence before they fork over big money to hedge fund managers.