By purchasing and reselling financial assets on the market, hedge funds and prop trading firms both seek to maximise profits. Despite the fact that both are intended to generate money, they function significantly differently and take very different kinds of risks.
Prop trading vs. hedge funds may be a topic on which you as a trader have many questions, particularly if you are new to the market. You should be aware that depending on the strategies you employ, these investment techniques may or may not be successful for you. But don’t worry—in this post, we’ll make sure you grasp the differences between hedge funds and prop trading before diving into the investment strategies.
What Is Prop Trading?
A bank or company engages in proprietary trading, also referred to as “prop trading,” when it trades securities such as stocks, bonds, currencies, commodities, their derivatives, or other financial instruments using its own funds as opposed to those of its clients in order to benefit from the transaction. Since they think they have an informational advantage over the competition, banks and businesses participate in proprietary trading.
When there is uncertainty over how a specific investment may perform in the future, they may utilise proprietary trading as a strategy to protect themselves against other investments. When losses do arise, these banks or prop businesses have a plan to mitigate them.
What Is A Hedge Fund?
A hedge fund is a limited partnership of private investors whose capital is managed by experienced fund managers. These managers employ a variety of tactics, such as borrowing money or trading in non-traditional assets, to generate returns on investments that are higher than average.
Investment in hedge funds is sometimes viewed as a dangerous alternative investment option since it typically has a high minimum investment requirement or net worth requirement and frequently targets rich clientele.
Hedge funds combine investor capital and make investments in securities and other asset classes in an effort to generate profits. Hedge funds often have greater freedom than mutual funds to explore investments and strategies that may raise the risk of investment losses since they are less strictly regulated than mutual funds.
Hedge funds are only available to institutional investors, such as pension funds, and wealthy people who can afford the higher costs and risks associated with hedge fund investment.
Prop Trading Firms Vs Hedge Funds
Using the money of its customers, hedge funds make investments in the financial markets. They are compensated for making money off of these investments. Proprietary traders put money from their company into the financial markets and keep all of the profits they make. Hedge funds are answerable to their clients, in contrast to proprietary traders. Yet, the Volcker Rule, which tries to restrict the amount of risk that financial institutions may take, also has them as targets.
By making investments in the financial markets, proprietary trading tries to improve the company’s balance sheet. Due to the fact that they are not handling customer money, traders can take larger risks. Companies engage in proprietary trading because they think they have a competitive edge and access to important information that will enable them to make significant profits. Only their companies are responsible for the traders. The gains generated by prop trading do not help the firm’s clients.
Prop Trading Vs Hedge Fund Costs
To determine which of these two investment strategies is the best, it is crucial to learn more about them. Prop trading company pay vs. hedge fund compensation is one thing that many traders would want to know as it will assist them decide the best course of action. Read on to learn more about how the businesses function.
There are a few requirements to be accepted as a prop trader. To make sure you are qualified for the role, a prop firm will ask you a few questions and perhaps do an interview at their prop trading company. The best aspect is that they divide gains with traders between 50-90%, creating a win-win situation. They essentially provide traders with fully funded accounts but you will usually need to pay a fee to take part in a trading challenge at first. So, before working for any prop company, it is essential to research their requirements.
A hedge fund corporation, however, has no restrictions. Whatever amount that an investor feels comfortable with can be invested. However, they must be individuals with substantial wealth, ranging from $200,000 to $5 million. This is due to the fact that hedge funds borrow money from many sources since they actively engage in various financial markets. Investors are often charged fees in accordance with the volume of assets managed by the hedge fund. This accounts for 2% and 20%, respectively, of assets and returns.
Main Differences Between Hedge Fund and Prop Trading
To hedge simply means to protect your investment against unpredictable times. Hedge funds are a diverse type of investment strategy that makes use of a well selected pool of affluent investors’ money to generate absolute returns using sophisticated trading strategies and aggressive asset management methods. A different business strategy, known as proprietary trading, uses a company’s own funds to invest in order to profit from rapid fluctuations in asset market prices. Prop traders’ interests in profitability do not coincide with those of their clients.
Hedge funds are subject to fewer, if any, constraints on their investment techniques and the asset classes they may invest in. They also have flexible investment rules. Hedge fund managers have an advantage over other asset management techniques like prop trading since hedge funds are less regulated and SEC laws do not apply to hedge fund activities in any capacity. Prop trading, on the other hand, entails greater risks due to the fact that it does not involve customer money. Also, the Volcker Rule forbids big institutional banks from participating in prop trading.
In addition to management fees, hedge fund managers also charge a sizeable amount for their services. Often times, the fees are closely related to the fund’s performance during a specific time period, subject to a “high water mark”. If losses have been accumulated, the fund management must meet the promised rate or return over a predetermined level. On the other hand, by trading on behalf of its clients, prop trading earns direct market gain as opposed to collecting a commission charge. This might lead to the realisation of all profits from an investing strategy.
To boost performance, hedge funds use aggressive asset management strategies and intricate trading. The money comes from organisations like endowments or pension funds, life insurance companies, endowments, and other controlled funds, as well as highly rich people who risk losing money via aggressive trading. Prop trading involves taking positions in commodities, currencies, asset-backed securities, interest rate and credit instruments, mortgage-related securities, and their derivatives. They frequently borrow money and use the collateral from their trades as leverage.
Proprietary Trading & The Volcker Rule
The Dodd-Frank Wall Street Reform and Consumer Protection Act includes the Volcker rule. Paul Volcker, a former head of the Federal Reserve, made the suggestion. The regulation tries to prevent banks from engaging in specific speculative transactions that do not directly benefit their depositors. During the global financial crisis, when government authorities found that big banks were taking too many speculative risks, the bill was suggested.
Volker maintained that high-speculation investments made by commercial banks had an impact on the stability of the whole financial system. In order to reduce risk, commercial banks that engaged in proprietary trading boosted their usage of derivatives. Yet frequently, this raised danger in other areas.
According to the Volcker Rule, banks and organisations that hold banks are not allowed to engage in proprietary trading, own hedge funds, or participate in private equity funds. Banks prioritise satisfying consumers from a market-making perspective, and income is based on commissions. But, from the perspective of proprietary trading, the consumer is unimportant, and the banks take home all the money.
Separating the two roles will make it easier for banks to maintain objectivity when engaging in customer-focused operations and preventing conflicts of interest. Major banks have either totally shut down or split their proprietary trading functions from their core business operations in reaction to the Volcker regulation. Specialized prop trading companies now provide proprietary trading as a stand-alone service.
Like the Dodd-Frank Act, the Volcker Rule is largely disliked by the banking sector. It is considered to be unneeded and harmful government intervention. For instance, as was already said, banks’ proprietary trading gave investors access to crucial liquidity. The liquidity source is no longer available.
Due to the minimal regulation of hedge funds, fund managers have more leeway to rely on a variety of pooled investment vehicles, such as limited liability corporations, limited partnerships, and trusts. Yet, because the managers must achieve a certain level of economic performance in order to be permitted to charge an incentive fee, the returns of hedge funds are often not dispersed. Prop trading is quite similar to the investing strategy used by hedge funds, with the exception that it focuses exclusively on trading for the benefit of the business itself and doesn’t include clients.