For years, the investment funds run by Wall Street legend Bernard L. Madoff turned in such consistently strong results that they seemed unbelievable.
It turns out that they were, federal authorities say.
As details of one of the largest alleged frauds ever to rock Wall Street began trickling out Friday, it became clear that warning signs about Madoff's funds had abounded for years.
But many investors, in a bull-market rush to get in on the action, either ignored the red flags or didn't bother to look for them.
"We felt it was too good to be true," Charles Gradante, co-founder of hedge-fund research firm Hennessee Group, said of Madoff's investment performance. "You can't go 10 or 15 years with only three or four down months. It's just impossible."
But some of Gradante's clients dismissed his admonitions and invested with Madoff anyway.
"They said, 'He's much smarter than you are,' " Gradante recalled.
The 70-year-old Madoff was arrested Thursday on charges of running what amounted to an old-fashioned Ponzi scheme: reporting illusory profits and paying off one set of investors with cash raised from others.
According to authorities, Madoff admitted wrongdoing and estimated that his scheme had cost investors $50 billion.
That would make it the country's largest-ever Ponzi scheme and the second-biggest worldwide, said Tamar Frankel, a Boston University law professor who is writing a book on the subject.
"It's on such a massive scale, it's mind-boggling," said Peter Turecek, a fraud expert at consulting firm Kroll Inc. "Fifty million would be a large fraud. Fifty billion is absolutely frightening."
On Wednesday, Madoff told two senior executives at his firm -- reportedly his sons, who helped run Bernard L. Madoff Investment Securities -- that he wanted to pay bonuses to key employees immediately rather than in February, as was customary, according to a civil complaint filed by the Securities and Exchange Commission.
Madoff eventually divulged that his funds were almost out of money and that the operation was "all one big lie," the complaint said.
The alleged scheme dated to at least 2005, according to authorities, and appears to have unraveled as investors asked for their money back during the bear market that began 14 months ago.
The case is another blow to the public perception of a financial industry that many Americans blame for the country's current economic problems.
"Wall Street's image is already tarnished, and this is another kick in the groin," said Peter Schiff, head of brokerage firm Euro Pacific Capital in Darien, Conn.
In particular, the high-profile blowup is likely to further damage the hedge-fund industry, which is suffering its worst year on record and is coming under increasing scrutiny for its furtive business practices.
The average hedge fund is down 18% this year, and many funds have angered investors by barring them from withdrawing their money.
"There definitely is some overflow that will tarnish the whole hedge-fund industry," Gradante said.
The case evoked gasps on Wall Street, where Madoff, a former chairman of the Nasdaq Stock Market, was considered a standard bearer for the industry.
But Gradante and other experts said they had long suspected something was fishy with Madoff's funds. To them, the surprise was that it took so long for the operation to be exposed.
One of the biggest red flags, experts said, was Madoff's improbably steady investment returns despite exceedingly volatile markets.
After studying Madoff's records at the request of clients, Gradante said he couldn't figure out how Madoff was churning out his performance and urged investors to be careful about placing money with him.
Over the last 18 years, hedge funds have gained an average of almost 12% a year, but the returns have fluctuated sharply from year to year, according to Hedge Fund Research Inc. in Chicago.
Madoff claimed an average annual return of better than 11% but with very little volatility, according to a person familiar with the matter. The firm purported to be returning a steady 1% or so a month and to have never suffered an annual loss, this person said.
There were other red flags.
Bloomberg News reported that a research firm warned clients away from Madoff's firm after discovering that its books were audited by a three-person accounting firm in suburban New York -- hardly the accounting powerhouse that would be expected to vouch for the records of funds holding billions of dollars.
Madoff also kept his funds under intense secrecy and was "cryptic" about how they operated, according to the SEC. Madoff ran the portfolio-management operation on a separate floor from his primary stock-trading business.
There also appears to have been sporadic rumors in investment circles over the years about troubles at the firm.
On Friday, outside the Manhattan building housing Madoff's headquarters, a man passed out copies of a page from an Internet stock-trading site.
A message purportedly posted by "trademonster" in January 2006 reads: "I've heard that SEC is going to shut down Madoff financial and all of their hedge funds for SEC violations. Can anyone confirm this?"
The man handing out the copies Friday identified himself as an independent trader but declined to give his name.
Some experts said the government should have uncovered the alleged fraud years ago.
Regulators appeared to be "asleep at the switch," said attorney John Hueston, a partner at Irell & Manella in Los Angeles and a prosecutor of Enron Corp. executives.
In a statement Friday, the SEC said it examined Madoff's firm in 2005 and 2007, finding three trading-related violations in 2005, but did not pursue any enforcement action.
Barry Minkow, who went to prison for a 1980s stock scam and now runs a company that investigates potential fraud, said Madoff may have turned to deception after incurring a big loss that he didn't want to disclose to investors.
"He thought there was a cure around the corner," Minkow said, "that he was a good trading day away from righting every wrong to pay everybody off."
Frankel, the Boston University law professor, had a harsher view.
"There is a type of person," she said, "who doesn't have shame or empathy for the people whose money he's taking."
Times staff writer Matea Gold in New York contributed to this report.