What is a hedge fund? Forward looking due diligence on whether the manager's strategy is likely to produce absolute returns in DIFFICULT times is surely the acid test. The subprime meltdown has revealed numerous beta repackagers but their bull market dependence was obvious. Plenty of alpha exists at the manager and strategy selection level. If a fund can't make money or manage risk in down markets, it's just not skilled.Anyone with genuine talent and experience knows illiquidity gets expensive during financial turbulence. Hopefully other investors dumb enough to gear up long only in subprime CDOs and other credit exotica and think they wouldn't have to pay the piper will be wiped out. Like every meltdown it is a POSITIVE development to shake out the weak and an alpha opportunity for REAL hedge funds.Subprime mortgages still seem to be causing trouble and the effects are NOT yet fully "contained" despite what the vested interests claim. Some hedge fund managers like John Paulson positioned well and some credit risk premium players like Bear Stearns Asset Management, Dillon Read Capital Management, Queen's Walk and Caliber revealed their lack of skill and NON hedge fund status. I never considered any of these fools since they were obviously not hedge funds despite claiming to be.There WILL be others; skill is rare so other incompetent "hedgies" marketing themselves as hedge funds have probably been caught out too. Being forced to adjust April performance numbers from -6.5% to -19% shows just how poorly Bear Stearns's portfolio managers had stress tested for difficult conditions or understood credit markets. Why do amateurs think the good times will last for ever?There has been a lot of commentary on the so-called Bear Stearns hedge fund debacle. It will indeed negatively affect the markets particularly in leveraged credit structured products but it just enhances the case for quality hedge funds. It was clear since inception that Bear Stearns' two troubled credit investment products were never hedge funds. They were just playing credit risk premium spreads and dependent on stable credit conditions.A few due diligence questions to detect a proper hedge fund IN ADVANCE. 1) Will it make money in a bear market for equity or credit? 2) Are the potential returns sufficient to compensate for the illiquidity risk? 3) Is most of the personal wealth of the senior management of the sponsoring firm invested in that particular product? A true hedge fund would be able to answer "yes" to each question but it was all "no's" for the elegantly named Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund and its "safer" sister. More questions 4) Will you blame funding counterparties if you blow up? 5) Is your "hedge" really a hedge? 6) How independent is your "independent" valuation. There is NO excuse for not understanding how the game is played or the behavior of your portfolio in ALL scenarios. There have been numerous credit collapses in the past; it is only if you just look at "recent" data that credit looks consistent.The familiar problems of overoptimistic model assumptions, stale valuation, gearing up thinly traded assets and disguising beta as alpha to charge higher fees emerge yet again. Whether it is SIVs, emerging market equities, rare metals or violins, if a fund isn't likely to thrive during future NEGATIVE return periods for the assets in which it trades then it is NOT a hedge fund. Investors should not relax the criteria differentiating a real hedge fund from a bull market product. Hedged means you are able to manage your risks and STILL generate performance with such insurance in place. I can't forecast but I can certainly anticipate and prepare for ANY eventuality.Credit hedge funds will receive end of quarter pricing marks soon. Will others soon join Bear Stearns, Cheyne Capital and Cambridge Place in getting rather different prices than their "mark to model" valuations implied? Definitely. Pricing to a model is fraught with issues not the least of which is ASSUMING the model is correct. There was obvious serial correlation and Sharpe ratio "enhancement" when I looked at those funds and some others in the credit space over a year ago. Model arbitrage is a great investment strategy since counterparties tend to think they have made money out of you, until the tide turns. Then they also discover that they are short lots of optionality and will not be able to cover that negative liquidity, convexity and gamma anywhere near prices they assumed.The biggest risk in pricing models is Assumption Risk. The trouble with bull and bear markets is that the price behavior and the width of bid-offer spreads can be quite different under the two regimes. If you are in roach motel assets getting out can become expensive. Bear Stearns was leveraged long CDOs of illiquid securities and "hedged" by shorting liquid ABX indices. As with similar problems in the past, the funds were long illiquid, short liquid. If a fund is leveraged and can only sell to a limited number of counterparties that KNOW it has a problem, getting out becomes difficult. Software for measuring risk doesn't help when risks are unmeasurable. And aren't you supposed to have proper risk management in place BEFORE you lose money not AFTER the fact?You really have to know what you are doing when designing models of prepayment and mortgage default risks; nothing in the academic literature or public domain works. Credit is neither stochastic nor continuous and when it jumps it really jumps. I can count the number of good mortgage-backed securities hedge funds on one hand but I would need many more limbs for the traders who have been blown away by not having adequate trading AND quantitative abilities to manage ALL the exposures in this complex field. When a product is very thinly traded, indicative dealer prices are pretty useless. If a fund is investing in illiquid instruments the fund valuation needs to be marked to the real bid, in size. Mark to market is possible only when there is a market.There is nothing inherently wrong with investing in "untraded" assets provided the risk-adjusted returns are sufficient to compensate. In bearish credit conditions ideally you usually want to be long the liquid and short the illiquid but weaker credit funds and less experienced managers do the opposite. Of course there have been skilled hedge funds in the areas of distressed debt and collateralised loans for a long time but their returns have justified the risks. But with some funds, even with apparently high absolute performance, often the excess RISK-ADJUSTED returns (the alpha!) was negative.Just as with Long-Term Capital Management, being long the illiquid and short the liquid works well until the market reverses and then years of consistently positive months get given back in one massively negative month. Leverage, liquidity and valuation risks are ONLY worth taking if you are compensated for those risks and plainly this was not the case. This is where investors in a hedge fund need to look at whether the potential returns justify the potential risk. With good hedge funds it does but NOT with the many "hedge fund" journeyman.With public equities, liquid bonds, fx and futures valuation is immediate, transparent, generally unarguable and there is plenty of alpha available in these liquid arenas IF you have the tools and expertise to find it. While liquidity is a variable even on an exchange you have access to the widest number of potential buyers and sellers. Venturing into illiquid areas raises the risk exponentially when there are much fewer counterparties to trade with. Leverage just exacerbates those problems. Funds investing in illiquid assets should be targeting MUCH higher performance than liquid funds as compensation for that extra risk. Yet some investors seems to compare them side by side without modelling the non-linear risks of gearing thinly traded securities.What's even worse than a closet index fund? A leveraged closet index fund. And that is what most of these toxic waste CDO funds were in effect running. Making money in BAD conditions is what hedge fund clients pay the 2 and 20 for; long only funds are the ONLY products you need in good times. Having criticised some of John Bogle's thinking in my previous post let's make something clear; index equity and credit funds are the best investment IF (and only IF!) you think the asset class is going up. It is a waste of time and money to allocate to higher fee actively managed funds that simply fall apart when their underlying market falls apart.Investors need to verify that a money management product purporting to be a hedge fund and charging hedge fund fees actually is one. Out of 10,000 funds that claim to be hedge funds, how many actually are hedge funds? The best estimate I have is maybe 25% tops. But of those how many are skilled? Perhaps 500-1000 at most. In other words probably only 10% of products that say they are hedge funds actually are GOOD hedge funds. Skill is rare by definition. While some investors might be discouraged by the bad news of 1/10 odds of picking a skilled fund, the good news is that they CAN be isolated in advance.Identifying a good hedge fund is as rare a skill as being able to identify a good security. Some multi-manager products and weaker funds of funds have reduced their fees because they think picking hedge funds is easy! Most of them don't have the experience or analytical resources to decide what is and what is NOT a hedge fund, let alone trying to find the BEST ones. It is difficult but NOT impossible. Do "lower" fees help if an "advisor" puts you into a fund that drops 100%?There will always be semantically-challenged products that screw up which is why due diligence and alignment of interests are so important. Investors should select real hedge funds NOT leveraged beta products that SAY they are hedge funds. The industry needs to rid itself of non hedge funds who can't measure, manage or hedge their risks and ride beta when proper managers aim for alpha. Fortunately we can rely on the market to conduct these shakeouts over time. Unfortunately for some amnesiac investors it has been a long time since difficult credit conditions.The colleagues of Ralph Cioffi may have liked the fund but how much personal cash did James Cayne have in? A necessary condition for a product to be considered a hedge fund is to verify senior management are eating their own cooking. In bull markets many unskilled traders make money; it is bear markets that tend to show who is good and who knows how to hedge. Many REAL hedge funds are MAKING MONEY out of these ongoing credit events. Marketing something is a hedge fund does not mean it is.