Mike Norman, anchor, HardAssetsInvestor.com (Norman): Welcome back everybody. I’m Mike Norman, your host. We’re here for the second half of my interview with Monty Agarwal, who is the author of the new book “The Future of Hedge Fund Investing.” Let’s talk about ... you have a chapter in there, the “Five Inviolable Commandments” for hedge fund investing. What is that all about?

Monty Agarwal, author, “The Future of Hedge Fund Investing” (Agarwal): Right. I mean, obviously as we saw in 2008, the biggest Ponzi scheme in the hedge fund was Bernie Madoff when he stole $65 million. What I’ve done is come up with a very concise list of five things. If investors were to just follow those five things, at least it will avoid them losing money to the next Ponzi scheme.

Norman: Really? Five things?

Agarwal: Just five things.

Norman: What are they?

Agarwal: Very simple. One, when you’re conducting your due diligence on a hedge fund manager, make sure he has an independent, well-recognized auditor. No. 2, make sure there’s an independent custodian – somebody who’s holding your cash and your assets and it’s not the hedge fund manager who’s holding it. Three, an independent prime broker, so the hedge fund manager is not executing the trades themselves and cooking up the fictitious trades. They’re being done by a third party. No. 4, independent NAV calculations, so you know the returns, so the hedge fund manager’s postings are actually calculated by an independent party. And he’s not sitting there saying, “Oh yeah, I’m up 30 percent.” And No. 5 – very important – the manager is willing to sit down with you across the table and in very simple English explain to you how he generates returns.

Norman: Now if the folks had that checklist of five things, would they have avoided getting into that Madoff situation?

Agarwal: Very, very easy; yes.

Norman: Really?

Agarwal: Not just Madoff, but I’ve actually done a case study, and I mention in my book the last five or six big hedge fund scandals. And you don’t even have to go down the list; just the first one off the list would be like, “Okay, fine; that’s a red flag. I’m not going any further.”

Norman: Do you think that greed is a part of it in a … I’m talking about on the part of the investor. Like they’ll see a guy like Madoff or somebody who purportedly has these unbelievable returns, unmatched, and they want to get in so bad that they’re willing to kind of skirt over the five points or doing the due diligence.

Agarwal: Do you know, I know a lot of high-net-worth individuals, especially down in Palm Beach, who conduct more due diligence on a $100,000 car than they would investing $10 million?

Norman: On a $20,000 used car. I mean, they’ll kick the tires.

Agarwal: Exactly.

Norman: But then they’ll wire $10 million into some trader’s account.

Agarwal: Exactly.

Norman: And for them it’s like cocktail party chatter: “Hey, I’m in Madoff’s fund.” It was like social status.

Agarwal: Of course.

Norman: It was part of the marketing … I guess you could call it a genius. It was an evil kind of a genius. But he made it so that that was part of your social status that you go in, right?

Agarwal: Absolutely. The first chapter in there, actually, has a lot of anecdotal, entertaining tidbits about that.

Norman: All right, now that’s for the individual investors. Now you also write about what institutions have to do to protect themselves, to make sure they at least have a chance of getting in a very reputable, well-run hedge fund.

Agarwal: Exactly. The five inviolable commandants should be followed by everybody. But then we look at the pension funds, institutional investors who are in charge of people’s retirement money. They have very, very big fiduciary responsibilities. They need to make sure that it’s not just about the initial due diligence that you conduct on a hedge fund, but ongoing due diligence as well.

Most of the pension funds, obviously, do not have the required expertise themselves. They need to make sure that their consultants, their advisers have traded capital before. If you’re investing in a hedge fund, you’re basically investing with a bunch of traders. You’d better have advisers who have traded before, who will be able to understand what the traders are doing at these hedge funds.

Norman: Now you’re saying this is a problem, because you’re saying that a lot of these consultants who work directly with the pension funds, the institutions that ultimately invest, the consultants have no experience as traders.

Agarwal: Exactly, which is very surprising. I’ll give you an example: Fairfield Greenwich Group that was invested with Madoff. They invested $7.5 billion and lost $7.5 billion.

Norman: The whole thing?

Agarwal: The whole thing. They had 21 partners. And they used to have the bios of these 21 partners on their Web site before they took it down. Not one of them had any experience ever trading capital before or ever managing risk before. But they were all very good at raising capital.

Norman: I don’t know, I think the universe is something like 7,000 hedge funds right now.

Agarwal: It used to be a smaller number, yes.

Norman: I think a lot of these guys, their real talent is the ability to raise money.

A: Absolutely.

Norman: I don’t think they’re that good at making positive returns on that money. How do they do it? I mean, I’ve seen some of these hedge fund sort of symposiums where you have new guys get together and prospective investors come. And in a very short period of time, they’ll sign up in the hundreds of millions, maybe sometimes a billion right off the get-go.

Agarwal: Because, unfortunately, sometimes the reputations go further than actual due diligence. And Madoff, I think, was a prime example of that. But hopefully after this episode, and hopefully people read the book, and they’ll be able to understand how to conduct proper due diligence and hire experts. And one of the things that we do besides running a hedge fund, we have an advisory service as well. But we do provide guidelines and advisory services to pension funds and high-net-worth individuals on how to pick hedge funds.

Norman: All right, I just want to ask you quickly before we wrap it up – and you’re running a hedge fund – do you think there’s going to be a regulatory backlash? It seemed that way right after the crisis, but now that kind of abated. But do you think, at some point down the road, you’ll see legislation or some sort of very strict regulation on the operation of these hedge funds, which are largely unregulated?

Agarwal: True. They’re largely unregulated because of private partnerships. One thing I will highly recommend to the SEC is if you’re going to come up with one regulation, make sure it is something that enhances transparency. Make sure that their hedge fund follows those five inviolable commandments and they’re disclosing, at least to the investors, what exactly it is that they’re doing. At end of the day, a well-educated investor is the best is regulator.

Norman: And, as you said, the hedge funds have a very powerful lobby. They’ve got deep pockets. So the chances of meaningful regulation: probably not anywhere.

Agarwal: That would be difficult, yes.

Norman: Yeah, that’d be difficult. All right, Monty; thank you very much. Thanks a lot. Folks, the book is called “The Future of Hedge Fund Investing.”I’m Mike Norman; see you next time. Take care; bye-bye.