The flood of new money didn’t matter much to the “Ten”- but it mattered a great deal to the other 90. As the demand for hedge fund managers exceeded supply, in my opinion, a lesser quality of manager was being allowed to set up shop and run money.

Most people, when comparing a name like John Merriweather (LTCM) with one like Irv Kessler (Deephaven), before 1998, would pick the former over the latter as a "better" hedge fund manager. In my mind, there's no comparison - but I believe the reverse is true. You won't find another trader better at analyzing and understanding risk (in a matter of seconds, and in his head) than Irv Kessler. A trader like Merriweather (who ignored the relationship between risk and leverage) will eventually blow up; it’s just a matter of time.

And here's the most important element in determining a good hedge fund manager from a bad one: Their understanding and application of risk.

It's ironic that those hedge fund managers who have destroyed huge amounts of wealth have run risk in a manner opposite to the one I've described: They have increased leverage, with an increase in degree and a reduction in price.

If you refer to my piece on LTCM, you will see that they used heavy leverage in trades where “potential” volatility or tail risk was very high, like in risk-arbitrage or even long/short equity.

Even today, we see a very disturbing trend: Managers leverage more and more the worse “price” gets. When convertible bonds are expensive (a bad price to buy), we see managers buy more and leverage more - instead of selling bonds and de-leveraging.

To their way of thinking (ignoring risk), a smaller spread (return) can be increased if it's leveraged. And they feel justified in this because that's what they're being paid to do: Buy convertible bonds and make a certain return. Irv would say instead that this is a disaster waiting to happen.

And here's my main point. It isn't the concept of a hedge fund that's bad, as the media may believe. It is not the concept of a hedge fund that may add volatility to the market or may cause a blow up that dominates the head lines or even puts the financial system at risk. It's the improper execution of hedge fund strategies by inferior managers using detrimental concepts of risk and leverage that cause these things. This is why regulation is absolutely necessary.

Regulation should focus on correcting the problem by requiring full transparency. Experienced analysis then of that transparency is essential in weeding the good hedge fund managers from the bad. This is why the lack of transparency by Fannie Mae (FNM) and Freddie Mac (FRE) -- which by my definition are the largest hedge funds in the world (except maybe for General Electric (GE), is so worrisome.

The regulators need to bark up the right trees first.