By Martin de Sa'Pinto and James Molony
ZURICH/LONDON, Dec 17 (Reuters) - Bernard Madoff's alleged $50 billion fraud is another nail in the coffin of funds of hedge funds already struggling to convince investors they should stomach double fees.
The failure of several funds to act on red flags in Madoff's New-York based operations have raised concerns over their abilities to select the best hedge funds for clients, which is the core of their product offering.
"Frankly anybody who was invested in Madoff really has got trouble proving credibility as a house that's able to perform appropriate due diligence," said John Godden, chief executive officer at hedge fund consultancy IGS Group.
Madoff was arrested last week, charged with running a Ponzi scheme using funds from new investors to pay out existing investors -- many of whom were funds of funds -- rather than actually making investment returns.
The scandal comes as the funds of hedge funds model is already being widely questioned, with the diversification across strategies largely failing to protect investor assets.
In 2008 through November, the Credit Suisse/Tremont All Hedge index, a good indicator of funds of hedge funds performance, returned a negative 26 percent.
It did outperform the S&P 500's minus 38 percent, but that was a far cry from the absolute returns that most fund of hedge funds investors were promised.
The poor performance will be magnified by the failure of Madoff's fund, a sizeable component of the All Hedge index, and which Credit Suisse/Tremont marked down to zero as of end-Nov and may well trigger calls for more regulation.
RED FLAGS
Several funds said they had not invested in Madoff because of concerns over its operational procedures, such as the use of accountants and brokers very closely aligned with the fund and returns that were too good to be true.
"There are a lot of boxes that you would need ticked in a due diligence process that just could never be ticked by Madoff," said IGS's Godden.
Another red flag was the fact that Madoff did not charge fees, but relied on revenues from his proprietary brokerage business instead, others said.
Yet the fact that Madoff's brokerage fell under the gaze of the SEC may have reassured many, and the presence of so many fellow reputable funds was a likely further comfort.
"If everyone believes they are piggybacking off the due diligence of others, the risk is that no one does it," said Paolo Cristofolini, a former hedge fund manager.
And many fund of funds would have been aware that if they couldn't provide access to Madoff -- known as one of the best risk-adjusted performers in the business -- they could end up losing clients to rivals.
The U.S. hedge fund industry could see redemptions accelerate in the wake of Madoff, industry participants said, while others predicted a surge in regulation.
"There will be pressure and preference from the UK and European investor and advisors for these funds to be structured in more regulated environments with a greater regulatory oversight," said Tushar Patel, managing director of London-based fund of hedge funds firm HFIM. (Additional reporting by Jane Baird; Editing by Richard Hubbard)