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Is your hedge fund a ticking time bomb?

What's the best way to blow up a hedge fund without using dynamite?

A. No risk management
B. High financial leverage
C. Excessive concentration
D. Hoping…
E. All of the above



Hundred dollar bils on fire
Peter Kim | Getty Images

If Owen Li, the founder of Canarsie Capital was answering this quiz, he probably would've answered "E." On Wednesday, we learned that he essentially lost almost all of the fund's $100 million in assets. But that wasn't the most newsworthy part of the story. He wrote a letter announcing he was "truly sorry."

Read MoreOwen Li says he's 'truly sorry' for blowing up hedge fund

Dude … That's like telling your wife you're truly sorry you had sex with her best friend and oh, by the way, she's pregnant. I get it—you feel bad (you should), but people don't want to hear that. They would prefer for you to raise your hand and say: "I screwed up!" (FCC word choice — not mine.)

I imagine Owen and his remaining employees sitting around the conference room crafting a letter. "I'm sorry… No wait; let's put 'truly' in front of sorry — it sounds better."

"Maybe we should put the words in italics?"

As a writer, I understand word choice is important, but sometimes less is more. And as a fund manager, you need to know the difference.

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Although the rest of the letter sounded like he was taking some accountability, it's really hard to get past the "truly sorry" part. He went on to say that he made a series of "aggressive transactions" over the last three weeks to make up for poor returns in December. On the blackjack table, we call that chasing. You don't do it.

One of the first things everyone learns on Wall Street is: When you make a mistake, stand up and raise your hand. Then try and rectify the mistake. People want to hear a solution — if there is one. Tell them the facts and what you plan to do about it.

Li is a former trader at Raj Rajaratnam's Galleon Group, which closed its doors based on insider trading charges. Rajaratnam is currently serving time for illegal activity, but Li was never accused of wrongdoing — until now. (Ironically given the losses, it's safe to say this probably has nothing to do with insider trading.)

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I also worked at Galleon (before Li) and then went on to be a founding partner for a start-up hedge fund that grew to over a billion dollars in assets. So, I know his path very well. But if we had a guy at our start-up who was taking this level of risk with his fingers crossed, he would have been shut down immediately and forced to unwind his positions.

This kind of thing should be an anomaly but, truth be told, it happens ALL THE TIME. A guy has a few good years and thinks he should open up his own fund and put his name on the door. But I would say 90 percent of the people on Wall Street don't understand how to manage risk. They think that picking stocks is the key to a successful hedge fund. It takes many hats to run your own fund.

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I'm not sure if Li's investors will ever see any of that money again, but they could have some recourse if the fund did not act in accordance with its charter. The lesson here isn't that you should avoid putting your money into a hedge fund start-up. Sometimes you can negotiate a better deal if you're considered early money. And there are also long-term benefits to believing in somebody. But there are questions you should ask before ever sending the wire to invest all of your money — questions Li's investors should've asked:

  • How do you manage risk?
  • How much leverage do you use? What are the limits?
  • What parameters are in place to supersede a portfolio manager's decisions?
  • Do you have a general counsel for insider information?
  • Is there an investment board? How does a position get into the portfolio?
  • What quantitative measures of risk do you look at?

You need to have detailed answers to these questions and you need to have it in writing. If I was meeting with any potential fund manager trying to manage money and he didn't already have precise, well thought out answers to these questions, I'd walk away. Risk management is paramount to the success of a fund.

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This is what's really SCARY: If the market had worked in Li's favor, he would've made all of that money back and then some with his aggressive bets. His performance record would be excellent and he'd be able to raise more money. After a couple of years, he'd be looked at as downright brilliant. Someone you'd want to put your money with. So, he's not the only guy doing this – he's just the one who had it blow up in his face. There are other funds out there like this.

Let's hope investors learn from this cautionary tale.

You never want to call your fund and hear: "Thank you for calling Canarsie Capital. If you would like a sincere apology, press 1. If you'd like to hear a soothing love ballad, press 2. If you'd like us to mail you a Hallmark card, press 3. To accept our apology, please press 4.

Commentary by Turney Duff, a former trader at the hedge fund Galleon Group. Duff chronicled the spectacular rise and fall of his career on Wall Street in the book, "The Buy Side," and is currently working on his second book, a Wall Street novel. He is also featured on the CNBC show, "The Filthy Rich Guide." Follow him on Twitter @turneyduff.

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