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in stock market downturns. Such long-only managers are not true hedge fund managers—they are just attempting to take advantage of the 20 percent incentive fee.

Transparency is key. Investors ask about the degree of illiquidity in a market. What instruments are traded and how liquid are they? Investors want to know how these illiquid instruments are marked to the market (i.e., priced)—it should be done by someone outside the firm, and there should be more than one source. They want to make sure the approach is consistently applied. Investors should make sure the formula in the document detailing how the process will be carried out is the one actually applied.

Investors now make an effort to quantitatively measure a manager's ability to liquidate positions. The general rule of thumb is that it takes one to two days for a long/short hedge fund; one week for a convertible arbitrage fund; three months for a distressed fund. Some investors suggest looking at the bid-offer spread as a gauge. The tighter the spread, the more liquid the stock.

Investors are now wary of funds that are near capacity, because they may have passed capacity. Long-Term Capital Management had reached close to $7 billion by the end of 1997 and gave back $3 billion to maintain good performance. It had already passed capacity. As it turned out, size was a major factor. In 1997 when asset size was at its peak, spreads were shrinking, which meant fewer trading opportunities. Spreads were shrinking because rival banks and competitors were entering the arbitrage business. Almost every investment bank on Wall Street had to some degree been getting into the game.14 With a common European currency, the easy money on convergence in Europe had been made. With borders disappearing, the spread between Italian and German bonds had shrunk.15

Due to these diminishing opportunities, LTCM returned profits on money invested during 1994 and returned all money (principal and profits) invested after that date.16 LTCM also strayed outside its area of expertise into Brazilian and Russian bonds and Danish mortgages. It made more directional bets, abandoned some of its hedging, got deeper into equities, and lost all sense of scale.17

Investors now make a better attempt to understand noncorrelation. An often-heard statement in 1998: "The only thing that goes down in bear markets is correlation between asset classes."18 During severe dislo-