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8:30 AM Wednesday, September 7, 2005: Hedge funds promise magic and sometimes deliver. But the hype far exceeds the performance. Hedge funds range from funds that "hedge" -- i.e. aim to preserve capital (their original concept) -- all the way to those who gamble extravagantly in order to maximize returns (and risks). Then there are the hedge funds which are plain out crooked, aiming to steal money from their investors -- a task made easier by the lack of regulatory oversight. I'm not arguing for regulation. I'm arguing for caution and constant vigilance.

Nothing is more precious than the capital we own. Nothing is more important than preserving that capital -- even if it means earning 3% on our money in the bank, instead of 33% at our local hedge fund. The enormous Bayou Group disaster has prompted much soul-searching and lesson-seeking, as reflected in a story by the talented Gretchen Morgenson in Sunday's New York Times:

Connect the Dots. Find the Fees.

TO many investors, the collapse of the Bayou Group - a hedge fund company and brokerage firm run by Samuel Israel III - may seem like just another financial mishap, and a calamity only for those who had the bad luck to invest with Mr. Israel or to be steered his way by advisers they were wrong to trust.

But actually, the mess at Bayou, which federal prosecutors are now calling a $300 million fraud, should be a clarion call for caution among the many investors who have been throwing money at hedge funds recently. This is especially true for institutions -- endowments and public pension plans -- that have flocked to hedge funds with the hope of increasing their returns. Because many of these institutions are having financial difficulties -- low interest rates are cutting deeply into their returns -- they are too often captivated by investments that seem to promise outsized gains with little risk.

"Our unique multifactor risk model acts as a road map for navigating risk and provides investors with alternative routes to reach their investment summit," Steve Henderlite, a co-founder and principal of Trail Ridge Capital L.L.C., said in a press release from October 2003. Trail Ridge Capital is a hedge fund and fund-of-funds company that had clients in Bayou. Mr. Henderlite did not return a phone call seeking comment.

Trail Ridge is also an adviser to a new investment fund, the Undiscovered Managers Spinnaker Fund, offered to wealthy individuals by the investment unit of J. P. Morgan Chase. The fund, which started last November and had $7.3 million in assets as of March 31, held $662,602 in Bayou. J. P. Morgan says it has written that investment down to zero.

Central to the Bayou story, and to almost every other financial disaster of recent years, are conflicts of interest. At Bayou, these conflicts began in its brokerage unit, which executed trades for the hedge funds. Because the brokerage unit, Bayou Securities, was wholly owned by Mr. Israel, he was able to profit personally from the rapid-fire trading conducted by the funds he oversaw.

But some Bayou investors who got into the funds on the recommendation of investment consultants were confronted with another layer of conflicts. That is, the consultants who recommended the hedge funds to their clients and the funds of funds that bought Bayou shares for their investors often received compensation from Bayou for sending assets its way.

While some investors may not find fault with such an arrangement, institutional investors who have a fiduciary duty to their beneficiaries should definitely steer clear of the deals.

"In my view, if a hedge fund manager wants to pay a particular level of fees to a marketing agent, that's their business," said Orin Kramer, chairman of the New Jersey Investment Council, the oversight board for the state's pension system. "But as a fiduciary, I would be very uncomfortable dealing with a gatekeeper who is being paid on both sides of the trade."

Unfortunately, not all fiduciaries know where these conflicts lie. They are often well hidden.

"Pension consultants frequently have undisclosed financial arrangements with hedge fund managers that create a conflict of interest," said Edward A. H. Siedle, president of Benchmark Financial Services, in Ocean Ridge, Fla., a company that works for pension funds to investigate possible wrongdoing among outside money managers.

Mr. Siedle says the nature of these deals varies. Sometimes the payments come in the form of commissions on trades steered by a hedge fund to a brokerage firm that is affiliated with the consultant; in other cases the payments are fees paid by the fund based on the assets the consultant brings in. In one case, Mr. Siedle said, he found that a pension consultant received a partnership interest in the hedge fund to which it was steering clients.

SUCH payments were a part of the picture at Bayou. According to materials provided by the fund to a prospective investor in 2003, Bayou had several outside marketers that it paid either as a percentage of assets raised or through commissions to the promoters' "designated broker/dealer."

One of the firms that Bayou listed as an external promoter at that time was the Consulting Services Group of Memphis. Bayou also gave prospective investors the name of E. Lee Giovannetti, chief executive of Consulting Services, as a reference and as an institutional investor in Bayou.

Joe Meals, a spokesman for Consulting Services, said that the firm did act as a reference for Bayou in 2003 and that it had recommended Bayou funds to clients. But, he said, "We became uncomfortable with the operations at Bayou and made recommendations to all our clients that they redeem their accounts, and they did so long before any of these issues came to light." He added that Bayou "may have executed commissions through our affiliated broker dealer at one time, but not recently."

Consulting Services did the right thing in advising its clients to exit Bayou before the debacle. Others weren't so lucky.

In coming weeks, federal and state investigators will try to sort out what happened to the money that investors entrusted to Bayou. Because Bayou's minimum-investment requirement of $250,000 was smaller than that of most hedge funds, the firm unfortunately attracted a lot of individual investors. The United States attorney in New York is seeking the forfeiture of all of Bayou's assets, including $100 million seized by authorities in Arizona last May. How much Bayou's investors ultimately get back is anybody's guess.

Larger investors, especially those who are fiduciaries, should take a lesson from the losses at Bayou. Conflicts of interest in the financial world are often hard to uncover. But refusing to do the necessary digging is downright irresponsible.

First Day of Citigroup/Smith Barney Technology Conference:
Early presenters gave indications of solid (but not spectacular) business for the second half. Companies indicated strength across all geographies and expect a pick-up in Europe/Germany. Pricing is stable or growing across different verticals. The Big are getting bigger at the expense of niche players. Second half IT spending is looking promising, with normal seasonality expected. Today is second day. You can attend. It's on at the Sheraton New York Hotel. Here's the program. Click here.

What else you'll need in your Disaster Kit (yesterday's column): Several readers suggested a weapon. One reader wrote:

Harry says: "You'll need:
+ Water
+ Food
+ First aid kits, etc..."

Hate to be a party poop, Harry, but I'd strongly suggest a weapon....with plenty of ammo.

In New Orleans, the core of the bad stuff that followed the storm largely reflected a 3rd world mentality and conditions that already existed in New Orleans, including a sizable group of really bad guys, totally corrupt police and politicians, and huge wasted tax money.. So it should be no surprise that nothing worked.......except it was a damn good week for the criminals already making a good living there. The middle class moved out of town years ago leaving this very nasty underclass with a murder rate I think is ten times Boston, a city of equal size, and a few wealthy folks who apparently came out relatively well through all this. There are solid nasty politically incorrect reasons armed solders were required ahead of first aid and food/water relief. It wasn't good citizens looking for food and water for the elderly! Most of the historical crime, of course, as was the crime spree we recently all got to see and hear about, is black on black, as usual, so it doesn't normally make the 6 o'clock news. New Orleans is one of the worst cities in America for this stuff.

So, if you have to cross any bad lands in a disaster, you too will want to be able to protect yourself and your loved ones. Money alone won't do it. Interestingly enough, apparently Walmart's did not have any theft because they did have armed guards.

Words to the wise.

TiVo has now slashed the price of its digital-video recorders by as much as half. Better yet, the capacity of TiVo boxes is now up to 300 hours. Lifetime TiVo service is $299 which makes more sense to me than paying monthly. I figure if TiVo goes bust, someone will pick up the pieces and keep my service going. That may be wishful thinking. But it's worked, so far.

Second bargain of the week:

Newegg.com is selling 19" monitors from ViewSonic, Samsung, Sceptre, and Benq for $299.99. A 19" from Sony is $399.99. Ones from Rosewill and Fuji Plus are $289.99. One from Hyundai is $335.99. One from Samsung is $329.99. Not all have a DVI input, which, to me, is important. DVI gives faster images and sharper text. The monitors that look best -- on their specs -- are Viewsonic, Benq, Hyundai and Fuji Plus. I'll probably buy the Benq. It's fastest.

I don't make this up:
+ Bear Sterns won't allow its people to buy paper clips, figuring it can recycle.
+ Lovemaking can unblock a stuffy nose. Sex is a natural antihistamine. It can help combat asthma and hay fever.
+ "Gourmet lollipops" have become big business and sell for big prices, as much as a $1 a pop.



Wonderful humor from Bob Hope:
ON TURNING 70: "You still chase women, but only downhill."
ON TURNING 80: "That's the time of your life when even your birthday suit needs pressing."
ON TURNING 90: "You know you're getting old when the candles cost more than the cake."
ON TURNING 100: " I don't feel old. In fact I don't feel anything until noon. Then it's time for my nap."
ON GIVING UP HIS EARLY CAREER, BOXING: "I ruined my hands in the ring ... the referee kept stepping on them."
ON NEVER WINNING AN OSCAR: "Welcome to the Academy Awards or, as it's called at my home, 'Passover'."
ON GOLF:"Golf is my profession. Show business is just to pay the green fees."
ON PRESIDENTS: " I have performed for 12 presidents and entertained only six."
ON HIS FAMILY'S EARLY POVERTY: "Four of us slept in the one bed. When it got cold, mother threw on another brother."
ON HIS SIX BROTHERS: "That's how I learned to dance. Waiting for the bathroom."
ON HIS EARLY FAILURES: " I would not have had anything to eat if it wasn't for the stuff the audience threw at me."
ON GOING TO HEAVEN: "I've done benefits for ALL religions (I'd hate to blow the hereafter on a technicality)."

Recent column highlights:
+ US Tennis Open TV Schedule. Click here.
+ Manhattan Pharmaceuticals: Click here.
+ NovaDel Biosciences appeals. Click here.
+ Hana Biosciences appeals. Click here.
+ All turned on by biotech. Click here.
+ Steve Jobs Commencement Address. The text is available: Click here. The full audio is available. Click here.
+ The March of the Penguins, an exquisite movie. Click here.
+ When to sell your stocks. Click here.

Harry Newton

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. That money will help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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