Bernard Madoff ‘s self-described $50 billion Ponzi scheme will likely go down as the biggest financial fraud that happened right under people’s noses.

This isn’t just a story about wealthy country-club patrons who got duped on the golf course, although there are plenty of them. Hedge funds, too, overlooked the red flags that could have tipped them off to the risks of investing with Madoff.

The people who run those funds are supposed to be smarter than the rest of us and were paid handsomely to protect those able to invest in their funds, including individuals as well as pensions, endowments and more.

But they didn’t live up to those expectations — far from it, in fact. That could seriously rattle the $1.7 trillion industry by curtailing investors’ willingness to plunge more money into such funds.

Let’s just say that every single one of them was asleep at the switch, said James Hedges. who runs the hedge fund advisory firm LJH Global Investments in Naples, Fla. and is the author of the book Hedges on Hedge Funds. They were counting on someone else’s due diligence to be their own.

Hedges can speak from his own experience with Madoff dating back to 1997, when he met with the investment adviser about having Madoff manage a fund of funds — a hedge fund that invests in other funds — that Hedges co-ran with a private bank.

After two hours of listening to Madoff’s pitch, Hedges remembers asking him to start again and tell it like he was describing his strategy to a first-grader. That never happened, and no deal was done.

Caught up in the hype

Many others didn’t stay away. They got caught up in the hype that surrounded Madoff, a former chairman of the Nasdaq Stock Market who was known for investment acumen that produced consistently solid returns month after month. His firm made trades worth $1 trillion a year.

Madoff made a name for himself in wealthy circles in New York and Palm Beach, Fla. and among those connected to the Jewish community. His reputation as a trusted adviser also attracted some of the world’s biggest banking institutions, such as HSBC Holdings and Royal Bank of Scotland Group. and hedge funds or those that run funds of funds including Fairfield Greenwich Group .

Now it is alleged that Madoff’s success was just a sham — he paid off old investors with money from new investors. The scheme came undone in recent months when those looking for redemptions outpaced the flow of new money. Madoff was arrested Dec. 11 in what prosecutors say was a $50 billion scheme to defraud investors.

We had no indication that we and many other firms and private investors were the victims of such a highly sophisticated, massive fraudulent scheme, Jeffrey Tucker. founding partner of Fairfield Greenwich, said in a statement. The firm, which had worked with Madoff for nearly 20 years, estimated it had about $7.5 billion invested in vehicles connected with Madoff.

Hedge fund failures

That hedge funds could be on the losing end of Madoff’s scheme is no fault but their own. Sure, U.S. regulators deserve blame for failing to uncover this mess, too, but that doesn’t absolve hedge funds from falling down on the job.

Hedge funds typically used aggressive investing strategies that mutual funds can’t offer and are favored by wealthy clients and big institutions who can afford to meet minimum investment amounts that generally run more than $250,000. For that money, hedge funds, as well as funds of funds, are supposed to offer exceptional due diligence, meaning they provide thorough examinations of an operation’s management, investment strategies and business structure.

Had the funds taken the time to delve into Madoff’s business, they might have seen things they wouldn’t have liked. There was no third-party oversight, and his outside auditor, Friehling & Horowitz in New City, N.Y. was an unknown three-person shop, not a large firm that specialized in institutions. No one could replicate his investment strategy, but his returns were smooth and steady.

And maybe most worrisome was this conflict of interest: One of his sons was the chief compliance officer.

Why didn’t these big names do their homework? asked Andrew Schneider. managing partner at HedgeCo.Net, an online hedge fund research and services company in West Palm Beach, Fla. It is mind-boggling.

Due diligence failure

Unfortunately, such failures in due diligence happen all too often when investors focus on financial risk rather than operational risk, said Stephen Brown. a professor of finance at New York University who has extensively studied hedge funds.

Investors, in the case of Madoff, were so blinded by the reputation and returns that they didn’t dig deeper into how the place really worked. Some of that may have been a function of cost, Brown said.

Conservatively, due diligence costs between $50,000 and $100,000 per hedge fund, so the cost of performing due diligence on 10 funds for a fund of fund portfolio can reach $1 million. At the same time, most funds of funds charge a 1.5 percent management fee to investors. That means a $20 million fund of funds might bring in $300,000 in management fees, not enough to cover cost of due diligence, Brown said.

Brown thinks the Madoff case might be another cause of the collapse of hedge funds, which are already being trounced by the declines in financial markets in the past year and the rise in redemptions from investors. He believes that smaller funds with assets below about $13 million will be the most vulnerable.

There will certainly be a cleansing wind that will blow through this industry, he said.

That won’t be a bad thing. This case certainly tells you why.