The report by the House of Lords welcomed the draft EU law in principle but said the industry did not cause the recent financial crisis.
The draft law imposes too many restrictions on managers who want to market non-EU funds in the 27-nation bloc or invest in non-EU funds, the report said.
"We believe that the government should not agree the directive unless it is compatible with equivalent legislation with regulatory regimes in third countries and in particular in the United States, in order to avoid a situation in which alternative investment fund managers lose competitiveness at a global level," the report said.
It also criticised the law's "one size fits all" approach.
"We recommend that the government seek to tailor the directive in a way that respects the differences between the types of funds it covers. A possible solution could be to establish broad principles in the directive," the report said.
The draft law was rushed out last year in response to heavy pressure from the European Parliament and had there been more consultation ahead of the draft, many of its "shortcomings" would have been spotted earlier, the report said.
Activist hedge funds were "perceived as villains" during the height of the financial crisis, particularly their favoured strategy of short selling shares, the report said.
The draft law should be amended so that managers can use non-EU depositories for safe keeping of assets and to sub-delegate custody functions, the report said.