Hedge funds face questions about the reason for their existence as they struggle to generate positive returns. The economic environment, regulation and scarce capital also threaten the industry.

The raison d'être of hedge funds is being questioned as performance becomes more correlated with other asset classes, according to Brian Lawson, chief global economist at political risk analysis company Exclusive Analysis.

"The hedge funds industry really went through a dramatic period of growth by offering uncorrelated and sizeable positive returns and that has been underlying its growth for the last decade," says Lawson. "This year we have had a much more correlated level of performance and negative returns in many funds."

He says if the performance of hedge funds is very similar to other asset classes, investors will naturally migrate to lower-cost investments.

Other significant challenges for the industry lie in regulation and the availability of banking capital, he says. "If the banking system in Europe gets into a very unpleasant crisis, funding for hedge funds is going to become even more restrictive than it has in the post-2007 period."

In order to meet these twin challenges, Lawson says hedge funds will have to be aware that the rules are changing and that they cannot necessarily continue with the two and 20 fee model. (See the January issue of Hedge Funds Review for an extensive review of trends in fee structures.)

He says the differentiator for hedge funds will be whether their business models have adapted to suit the current environment.

There may, however, be more pressing issues for hedge funds than just performance and market turbulence. Lawson says there is a serious risk of a breakup of the eurozone.

"If we are muddling along under a ‘Merkozy'-style regime with tight fiscal policy being imposed on most states, it is almost certain we are looking at a very low growth, if not recessionary, environment," he says.

"What happens if the eurozone really does breaks up in a violent and uncoordinated way that is a much more threatening situation."

If this happens "depression and a really nasty long-term environment is one we see as most likely". Germany and France could be sucked into the problems, he says.

Areas of growth in 2012 will be in the emerging markets, says Lawson. However, he adds there is a debate about whether China's growth will drop below 9%.