WASHINGTON (MarketWatch) -- The arrest of investment manager Bernard Madoff on allegations that he ran a $50 billion "Ponzi scheme" raises questions about the effectiveness of the Securities and Exchange Commission's oversight of the investment management industry.

The SEC and Department of Justice on Friday launched parallel suits against Madoff, 70, who oversaw Bernard L. Madoff Investment Securities LLC. Both agencies are trying to identify if any assets remain, but regulatory observers argue that there were several warning signs that should have triggered an SEC investigation much earlier.

“ The Madoff scandal couldn't have come at a worse time for the hedge-fund industry, which already is reeling from record losses this year. ”

Madoff's investment-advisory business was subjected to oversight by the SEC in 2006, but a regulatory observer familiar with the fund said that agency staffers in the SEC's Office of Compliance, Inspections and Examinations never conducted a serious scrutiny of the fund.

"The big concern is whether the SEC has adequate resources and the will to identify this kind of fraud," said Consumer Federation of America director Barbara Roper.

The agency is charged with examining the books of new funds registered with the SEC, with follow-up reviews taking place every three years for high risk institutions. Registered investment advisers that fell under the category of low risk are only subject to random investigation. There are no details about how frequently these fund managers are reviewed.

Columbia Law School professor John Coffee said that the agency is overworked and typically examines only 10% of the new funds that are registered.

He added that the SEC should have looked more carefully at Madoff, because he oversaw a huge quasi-hedge fund that was audited only by a tiny New York-based firm, Friehling & Horowitz. Madoff's fund also did not employ a reputable outside custodian, which is an institution that holds the assets of the fund. Finally, Coffee noted that a rival to Madoff raised concerns about the fund in 1999.

"The fact that this was such a huge fund that employed such a small audit firm and no outside custodian should have triggered red flags at the SEC," according to Coffee. "Funds of that size typically have a large internationally recognized auditor."

SEC enforcement-bureau director Linda Thomsen defended the agency at a press conference at the Justice Department, saying it is difficult to comment on the examination at this stage. In a statement Friday, the SEC said Enforcement division staffers in New York completed an investigation in 2007. The statement said it re-opened the investigation on Thursday.

"We are now acutely focused to figure out what is going on at the fund," she said.

Judge Louis Stanton late Friday granted the SEC's request to freeze Madoff assets and appointing Lee Richards, partner at Richards, Kibbe Orbe in New York to investigate Madoff and his firm.

According to SEC documents, the agency's compliance and examination's office employed 425 people as of 2007. This division looks at hedge funds, mutual funds and other institutional investors.

Both Coffee at Columbia and Roper at the Consumer Federation of America contend that the agency must allocate more resources to fund oversight, so staffers can audit more newly registered funds. Both high and low risk funds, Coffee said, should be examined more frequently.

A former SEC official noted that an agency Office of Risk Assessment, which was created in 2004 under then chairman William Donaldson, was "largely dismantled" until recently. The office was set up to identify problem areas, negative trends and forms of fraud associated with certain strategies employed by hedge funds and other entities.

He added that the office, had it been fully staffed, could have helped identify problems with Madoff earlier on. The office began to be re-staffed in March after the near-collapse of Bear Stearns Cos. and its subsequent government aided acquisition by J.P. Morgan Chase & Co.

The Madoff charges may also put more pressure on Congress to adopt hedge fund manager registration rules. Under Donaldson the agency in 2006 sought to gain greater oversight of the hedge fund industry by requiring investment managers with $100 million or more in assets under management to register and open up their books to agency examiners.

However, shortly after the rules were adopted, a federal appeals court rejected them on the argument that the SEC did not have statutory authority. Nevertheless, many managers that registered in 2006 to comply with the rules never de-registered after the regulations were thrown out.

House Financial Services Committee chairman Barney Frank, D-Mass., said earlier this month that he plans to introduce new hedge fund manager registration legislation. But Consumer Federation's Roper said that requiring registration is important only if the agency has sufficient staff to oversee the entire $1.5 trillion hedge fund industry.

"It's not just about jurisdiction, it's about whether they use that effectively," Roper said.

The fund affected a wide array of both high net worth and institutional investors. Ben Bornstein, director, Prospero Capital in New York, said he was surprised at the amount of people that had a disproportionately large amount of their net worth capital invested with Madoff. "He had a mystique in New York where people were just dying to get into his fund," Bornstein said.

Another hedge headwind

The Madoff scandal couldn't have come at a worse time for the hedge-fund industry, which already is reeling from record losses this year. Funds of hedge funds, which allocate clients' money to a range of underlying managers, have been hit particularly hard.

Such funds lost 18.5% on average this year through October, while the average single-manager fund was down 16%, according to HFR indexes.

That may be disappointing because funds of hedge funds are supposed to be more diversified and less risky than single hedge funds. They're also supposed to seek out the best managers and vet them for clients.

Union Bancaire Privee, the world's second-largest provider of funds of hedge funds behind UBS AG UBS, -0.54% , said on Monday that clients' exposure to Madoff's investment company is less than 1% of the private bank's assets under management. That would put customers' exposure above $1 billion. A spokesman for the Swiss bank declined to comment further.

Fairfield Greenwich Group, a firm with $14 billion in assets that runs its own hedge funds and allocates to other managers, had roughly $7.5 billion invested in vehicles connected to Bernard L. Madoff Investment Securities.

"We have worked with Madoff for nearly 20 years, investing alongside our clients," Jeffrey Tucker, founding partner of Fairfield, said in a statement late last week. "We had no indication that we and many other firms and private investors were the victims of such a highly sophisticated, massive fraudulent scheme."

There were several things that alerted some in the hedge-fund industry that an investment with Madoff may not have been as safe as it initially appeared.

Aksia LLC, which researches hedge funds and advises institutions about investing in the industry, said that it never recommended that clients put money in some of the "feeder funds" that allocated their capital to Madoff.

On the surface, these feeder funds looked like institutional-quality vehicles, but there were "a host of red flags," Aksia Chief Executive Jim Vos and colleague Jake Walthour wrote in a letter to clients after the Madoff scandal erupted last week.

The funds were marketed as using a "split-strike conversion" investment strategy that is "remarkably" simple, but the returns it purportedly generated could not be replicated by Aksia's quantitative analyst, Vos and Walthour wrote.

The Madoff funds supposedly traded in the Standard & Poor's 100 index options market, but that market is relatively small and may not have been able to handle trading by vehicles with roughly $13 billion in assets, they said.

The feeder funds had almost all their assets custodied with Madoff Securities, the brokerage unit of Madoff's firm. So Aksia checked into the auditor of Madoff Securities and discovered it was a firm called Friehling & Horowitz, which had three employees -- one of whom was 78 years old and another was a secretary. The firm's office in upstate New York was 13 feet by 18 feet, Vos and Walthour said.

Madoff's Web site claimed the firm was technologically advanced, but it sent paper confirmations of trades via U.S. mail at the end of each day, rather than providing electronic access to this important information, they added.

"Paper copies provide a hedge-fund manager with the end-of-the-day ability to manufacture trade tickets that confirm the investment results," Vos and Walthour wrote.