Hedge funds often trumpet their ability to deliver alpha risk-adjusted outperformance. But a vital part of their appeal to investors is that they can provide a diversified return when traditional asset classes such as equities and bonds are only expected to perform modestly. This raises the question of how hedge funds get their returns.

There are three benign possibilities. The first is that the managers are more clever than those elsewhere. The second is that they gain an advantage by using techniques (specifically shorting) that are not options for traditional fund managers. The third is that they can exploit anomalies in parts of the market (distressed debt, for example) ignored by other investors.