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).

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