Fundamental changes to the investment landscape and regulatory system will create increased instability and consolidation in the hedge fund market - and institutional investors should "hold off" investing in the pools until the volatility has cleared, say investment consultants Watson Wyatt.

In a note to its clients, Watson Wyatt said the current crisis will expose hedge funds that are "not structured to add value for investors" and many of them will close.

Regulators in the US, Europe and Asia have severely curtailed short-selling or banned the practice outright, while the credit crunch has prompted policymakers around the world to call for tighter controls on the sector, which historically has been relatively lightly regulated. More than 90 per cent of the world’s hedge funds are registered in offshore centres such as the Cayman Islands.

However, it added that once market turbulence subsides, the best hedge fund managers will be better placed to exploit investment opportunities generated by the market dislocations and lower prices it generates.

Investors in hedge funds, such as high net worth individuals, pension schemes, life insurance funds and other institutions, have suffered a poor year for returns. According to the Hedge Fund Research HFRX snapshot of returns between the start of 2008 and 22 November, funds are down 22.1 per cent.