As Warren Buffet, the most successful investor of all time, once noted, it is when the tide goes out that the world sees who has been swimming naked. But rarely has the world witnessed an exposure quite as traumatic as the collapse of Bernard Madoff's hedge fund.
When hedge funds first appeared on the financial scene, they were high-risk and high-yielding investment vehicles for the super-wealthy. But in recent years all manner of supposedly conservative investors, from pension funds to insurance firms, began ploughing cash into them, eager for a piece of the action. And so it is not just a handful of wealthy investors who have been scorched by the collapse of Mr Madoff's £33bn fund.
Losses are showing up in banks and financial institutions across the world. In Britain, HSBC and the Royal Bank of Scotland have admitted that they invested millions with Mr Madoff. Even local authorities in Hampshire and Merseyside were exposed. It is not just Mr Madoff who was swimming naked, but all those who invested money with him.
It is rather rich to hear supposedly sophisticated investors such as Nicola Horlick here in Britain blaming US financial regulators for not spotting what Mr Madoff was up to. It is no secret that hedge funds are inherently risky. Ms Horlick might do well to examine her own judgement for parking her client's money with Mr Madoff, rather than trying to shift responsibility.
Yet that is not to argue that the regulators are blameless in this sorry affair. Far from it. The US Security and Exchange Commission, charged with regulating the American financial sector, was clearly negligent in failing to scrutinise Mr Madoff's books. This is a symptom of a much wider regulatory malaise. The shadow banking sector, of which hedge funds are a central player, has been like the Wild West in recent years. Regulation has not been so much light-touch as non-existent. And this has been the case not just in the US but in London too, which is home to scores of hedge funds.
The Conservative Party leader, David Cameron, yesterday said there should be tougher penalties for financial fraudsters. Few would argue with that in the present climate. But the regulators also need to call time on insolvent traders before they implode spectacularly like Mr Madoff. Better regulation is essential. Investors must take responsibility, but we all need to be able to have confidence that the financial authorities are doing their job properly.
Some will argue this is all rather academic since the hedge fund model seems to be heading for extinction courtesy of the financial downturn. Hedge fund managers claimed to be able to generate stunning returns for investors in any economic conditions. And they extracted huge personal fees on the justification of their supposedly superior investment skills. But funds managed by the sector have posted vast losses this year. And investors are rushing for the door.
We now see that the impressive returns of the sector in the boom times were primarily a result of cheap credit. Fund managers made bets on movements in the markets with huge quantities of borrowed money. Now money is no longer cheap, their performance no longer looks so impressive.
Ultimately, the market will decide whether the hedge fund sector survives or not. But either way, there can be no doubt that the Wild West is in need of a competent sheriff.