Some investors own hedge fund portfolios that are exceptionally well structured, but let's face it-many others are assembled haphazardly. A poorly structured long-only portfolio will merely underperform, but a poorly structured hedge fund will be alarmingly prone to blowing up, permanently destroying your capital. Hedge funds fail because of both fraud and extremely poor manager decisions, the latter often having to do with the complicated subject of leverage.

The danger of a fund explosion notwithstanding, few investors focus on hedge fund strategies that might help shield their portfolios against serious capital loss. Sure, solid diligence, thorough background checks and constant monitoring are crucial. But in a world where Harvard University can lose $350 million on one fund meltdown (Sowood), no one is safe.

So let's assume that the first rule of hedge fund investing is-or should be-not to suffer a serious, permanent loss of capital as the result of unethical behavior or foolish decision-making by some fund manager. It's only after we've structured our portfolio to minimize catastrophic loss that we can turn our attention to the many details associated with diligence and with optimizing our hedge portfolios. But skipping Job No. 1-seeing to the return of the capital-can undermine a lot of other sound work.

Diversification, Diversification, Diversification
It's instructive to analogize individual hedge funds to individual stocks. They are very different animals in most respects, of course, but in one they are quite similar-namely in their tendency to explode and destroy capital. For every Enron there is a Long-Term Capital Management; for every Tyco there is a Bayou; for every Bear Stearns there is a Sowood.

On the equity side, most investors are well aware of the dangers of holding concentrated stock portfolios. Extensive research has suggested that owning as few as 15 to 20 carefully selected stocks can eliminate single-stock risk, leaving the investor with the return of the asset class, plus or minus a bit of outperformance or underperformance. But the key words here are "carefully selected." It's very difficult to construct a stock portfolio that doesn't double or triple up on industry or sector exposure, or to build one without subtle serial correlations. As a result, most investors own far more than the minimum 15 to 20 stocks-indeed, most investors own hundreds of individual securities.

Hedge funds might not be stocks, but if our concern is loss of capital-and again, that should be worry No. 1 for a prudent investor-then there is still a lot to learn here from the principle of diversification. How might that principle be implemented in the special case of hedge funds?

Two Simple Questions
Investors can arrive at the correct strategy for building their hedge fund portfolios by answering these two simple questions:

1. How much of my hedge fund capital am I willing to lose to any one hedge fund meltdown?
2. What is the average minimum account size of the hedge funds to which I am willing to commit my capital?
Let's take a simple example by assuming that the answer to the first question is "not more than 5%," and that the answer to the second question is "$1 million." The first answer tells us that we need to invest in a minimum of 20 hedge funds, and the second answer tells us that our hedge fund portfolio must be at least $20 million (20 funds times $1 million per fund).

At the wealth advisory firm where I work, the average client has liquid assets of roughly $150 million. So if a client plans to have a 20% exposure to hedge funds, his or her fund portfolio in this category would be about $30 million. No problem.

But suppose we aren't planning to put $20 million in hedge funds? Then the simple fact is that we can't bullet proof our hedge fund portfolios unless (a) we are willing to risk a lot more capital on a blowup, or (b) we can somehow find great hedge funds with very low minimum account sizes (good luck).

So What's A Poor Investor To Do?
Like it or not, many capital preservation-oriented investors will find that the best solution is to employ hedge funds of funds as the core of their hedge fund portfolio strategy, perhaps adding a few individual funds as "satellites." That brings us to the (dare I say "knee-jerk"?) reaction of many investors: "I hate funds of funds!"

It's not wrong to be skeptical. Of the roughly 1,000 funds of funds in existence, no more than 75 will be worth looking at. Just like most individual hedge funds, most of the fund groups don't justify their fees.

People tend to have two main concerns about funds of funds. The first is that the funds tend to underperform individual hedge portfolios. True enough. The HFR Fund of Hedge Fund Index typically underperforms the HFR Weighted Hedge Fund Index over longer periods of time. But it's also true that most active long-only managers underperform their benchmarks. Yet most people still prefer active management.

So let's look closely at what we are saying here. We are saying that we can pick individual hedge fund managers who will outperform, but that if we go with funds of funds we will pick one that underperforms. It's got to be one way or the other, folks-either we can pick outperforming funds or we can't. And if we pick lousy individual hedge funds we face blowup risk, while at least with lousy funds of funds we diversify that risk away.

Investors also hate the extra layer of fees that funds of funds charge.  But they don't charge this extra layer simply because they are greedy. They charge it because that's what it costs to do what needs to be done to build a soundly performing hedge fund portfolio.

Investing in hedge funds is a devilishly difficult business, and a good hedge fund of funds offers the same skill set any investor would need to build a successful portfolio of individual hedge funds:
Portfolio management
Strategy allocation decisions
Return and risk expectations and analysis
Liquidity analysis and capacity determination
Manager research
Identification, evaluation and sourcing of new managers
The ongoing monitoring of managers and relationship management
Structural risk analysis
Identification and monitoring of non-investment and operational risks
What would we have to pay for these skills if we had to build our own staff? Believe me, you don't want to know.

But What About Multi-strats?
Some multiple-strategy funds are among the best hedge funds in the business. But there are three issues that should give anyone pause-that is, anyone who imagines that he or she can build a bulletproof portfolio by using only multi-strats.
First, few of them are worth looking at. A multi-strategy hedge fund isn't really an investor-focused product, but a hedge fund manager-focused product. Most multi-strats started out life as convertible arbitrage hedge funds. The trouble with convert arb, if you are the manager, is that sometimes it's a productive strategy and sometimes it isn't. When it isn't, your investors leave and your staff resigns. What to do? You can build into your fund some other strategies, preferably ones that tend to be productive when convert arb isn't! It's brilliant! (Never mind that this manager doesn't know anything about any of these other strategies.)

Second, multi-strats tend to provide diversified exposure to multiple strategies when investors need it least (i.e., when most strategies are doing well) and fail to provide strategy diversification when investors need it most: when everyone gets enthusiastic about one or two strategies that turn out to be bogus.

Finally, and most important for our purposes here, remember that when we are at the point of structuring our hedge portfolio we aren't yet terribly concerned about strategy diversification. What we are concerned about is organizational diversification, meaning the possibility that any of our individual hedge funds, multi-strat or otherwise, might explode. As we know all too well (with Long Term Capital Management and Amaranth), multi-strats also do it.

A Brief Summary Of Sound Hedge Fund Strategies
Investing in individual hedge funds. This is the most common strategy and the most dangerous. It's to be avoided except by the extremely wealthy.

Investing in multi-strategy hedge funds. Multi-strats have their uses, but for investors who are concerned about catastrophic loss, multi-strats are no solution.

Investing in funds of hedge funds. Like it or not, this will be the prudent strategy for many investors, and will be a useful core strategy even for those who will build satellite exposures through individual hedge funds.

Gregory Curtis is managing director and chairman of Greycourt & Co. Inc., a leading provider of financial advisory services to wealthy families and select endowments.