Prop Trading vs Hedge Funds: Differences, Similarities & More (2022)

Hedge funds and Prop Trading firms are vehicles of investment created exclusively for traders who meet specific criteria.

Both have similarities and differences, advantages and disadvantages while maintaining an air of mystery to the general public.

To help de-mystify the world of hedge fund vs prop trading, I’ve put together this article to break down the basics of both types of firms along with the strategies they implement, their payment structures, what makes them similar to each other, and what makes them different.

While both require active management, can potentially provide more significant returns than other types of trading, and implement similar investing strategies, they do have a few stark differences between them.

Let’s go ahead and take a look at each, starting with how each type of firm works.

Table of Contents

(Video) The Difference Between Hedge Fund vs Private Equity

How Does A Prop Trading Firm Work?

Prop Trading vs Hedge Funds: Differences, Similarities & More (1)

Proprietary (Prop) trading is a type of trading carried out by banks and other trading firms where they use the institution’s own money instead of their client’s.

This is done to maximize profits from each successful trade rather than relying on receiving commissions.

Firms prefer this form of trading because it makes them the sole profiteer instead of acting as a middleman for their clients.

Now, they do pay a commission to us, their traders, but that’s still far away from the sub-1% they receive in traditional trading commissions

So, you may be looking for the answer to how do prop traders get paid. The answer is they can get paid in three different variations.

In the first variation, the prop trading firm takes anywhere between 20 – 50% of the trading profits.

In the second scenario, the firms take almost nothing from the trading profits. They simply charge software usage, seat, and training fees.

(Video) From Floor & Prop Trader To Hedge Fund Manager

And, the third method is employing people as floor traders. These are less experienced traders with a fixed income and no share of the profits. This is also a traditional job rather than online prop firms such as FTMO, TopStep, etc.

Each variation does come with hefty bonuses.

How Does A Hedge Fund Work?

Prop Trading vs Hedge Funds: Differences, Similarities & More (2)

The term hedge refers to protection. Just like a garden hedge that provides protection to a house, the idea of a hedge fund was to protect or minimize the risk posed to an investor’s capital.

However, that is not the case anymore.

A hedge fund has become a company that utilizes a pool of capital provided to them by qualified investors to implement high-risk strategies to generate as much profit as possible.

Hedge funds generally accept two types of investors – qualified investors and people well-known to the hedge fund manager.

To be considered a qualified investor, your personal annual salary must be above $200,000. You also need to have a net worth of above $1 million, be an executive or director of a company, or have a trust fund worth over $5 million.

(Video) The Prop Trading Alternative & Comparison

The strategies a hedge fund implements dictate the type of fund it is. The four strategies are:

  • Global macro.
  • Directional.
  • Event-driven.
  • Relative value (arbitrage).

A common high-risk strategy implemented by hedge fund managers is to leverage borrowed money in an attempt to increase returns.

Hedge funds also operate on a ‘2 and 20’ fee structure. What is a 2 and 20 fee structure?

This refers to the structure through which a hedge fund manager gets paid. Each investor has to pay a 2% management fee upfront and a 20% fee when the funds make a profit for the investor.

Do hedge funds do prop trading?

Although prop traders and hedge fund managers have similar investment models, hedge funds do not do prop trading as they only use money from investors to execute trades while pocketing a mandatory account fee plus a 20% commission off each profitable trade.

The Differences Between Hedge Funds vs Prop Trading

Prop Trading vs Hedge Funds: Differences, Similarities & More (3)

The difference in payment structure

Hedge fund managers make 2% fees upfront and only 20% of commission from profits.

Prop traders get to keep between 50 to 90% of their profits but do not get paid a salary unless they are floor traders.

(Video) Retail Trading VS Prop Trading (My Forex Funds, FTMO)

This means, prop traders can potentially make higher returns than hedge fund managers.

Trading style

Since a hedge fund manager’s pay is dependent on the profits without bearing any losses in case things take a turn for the worse, they tend to take higher risks to get paid higher commissions.

On the other hand, Prop traders err on the side of caution as they are executing trades with their own money.

Funding

Hedge funds run with investor money and are open-ended, meaning investors can leave at any time.

It also means that investors get to keep a majority of the profits made in each trade. Prop trading firms use their own capital, which means they get to keep their earnings.

Liquidity

Prop trading offers more liquidity as you can have as many open orders as you want.

Although hedge funds are open-ended, they are less liquid and require investors to lock in their money for a more extended period of time.

Pros & Cons Of Proprietary Trading

The Pros of Prop Trading Are:

  • You get to keep anywhere between 50 – 59% of your trading profits as a prop trader.
  • Firms provide training and mentorship to new recruits through their own experienced traders.
  • Due to training, new traders can become profitable much faster than in other trading firms.
  • Prop traders have a larger amount of capital to trade with compared to trading with their own funds.

The Cons of Prop Trading Are:

  • Prop traders are required to deposit a sizeable capital before trading with the firm’s money which will be used to cover any losses occurred while trading.
  • If you are not a floor trader, you won’t see any pay for a few months while you train and learn the ropes with your mentor.
  • To get paid a fixed salary as a prop trader, you need to be a floor trader. As more prop firms go online, there are fewer seats for floor traders, which means competition is very high.
  • You do not make 100% of your profits, but you bear 100% of your losses.

Pros & Cons Of Hedge Funds

The Pros of Hedge Funds Are:

  • The SEC does not monitor hedge funds as strictly as other firms as hedge funds are not publicly traded companies. This allows them free reign on the methods they implement to maximize their profits.
  • Since the hedge fund manager’s remuneration is based on the profits they generate for their investors, most can be depended on to make the best decisions to maintain profitability.
  • Due to the flexibility awarded to hedge fund managers, the diversity of their investment strategies helps to protect (hedge) most of their trades.

The Cons of Hedge Funds Are:

  • Although hedge funds are open-ended, they are less liquid and require investors to lock in their money for a period of time and can only withdraw money infrequently. This could be monthly or longer.
  • As an investor, you do not have any knowledge of the actions carried out by hedge fund managers using your own money as they do not require to disclose it.
  • Hedge funds can have confounding rules and fees, which can make it unclear how much of the profits hedge fund managers actually receive. A Chicago-based advisory company, Simon Lack, claimed hedge fund managers took over 80% of gross profit, leaving investors with less than 20%.
  • Due to hedge fund managers being able to take high-risk strategies and having the ability to borrow an unlimited amount of money, a simple mistake can lead to costly consequences for investors.

Conclusion

Due to the light regulation around hedge funds, investors can expect significant returns, while hedge fund managers can use almost any means available to them to generate these profits.

(Video) Prop Trading vs Retail Trading

However, the lack of regulation means higher risks are taken in this industry-leading to losses experienced on a massive scale.

Prop trading firms can implement s similar strategy structure. However, the firms use their own money to execute trades, leading to more cautious behavior.

If you are interested in finding out more about prop trading and how to become one, go ahead and read my article titled ‘What is Proprietary trading?‘ to get a better idea of it.

FAQs

Do hedge funds prop trade? ›

Prop trading exists at hedge funds, asset management firms, commodities companies like Vitol and Glencore, and small/independent trading firms – and it used to exist at large banks before the 2008 financial crisis. In practice, “prop trading” usually refers to the smaller, independent firms that focus on market-making.

What is the difference between prop trading and market making? ›

The answer to that is pretty simple: the market maker must be prepared to buy or sell whenever a client needs to buy or sell. In other words, he must be prepared to put a price on a trade even if he doesn't want to. Hence, he makes markets. The proprietary trader, on the other hand, gets to decide ...

What are some similarities and differences among mutual funds pension funds and hedge funds? ›

1. Mutual funds, pension funds and hedge funds are all financial institutions involved with helping savers and investors reach their financial goals. 2. Unlike mutual funds and pension funds which serve investors of all means, hedge funds are primarily designed for wealthy investors and endowments.

What is the difference between hedge fund and fund? ›

Hedge funds are free to trade in anything they like, whether that's stocks and derivatives, land, real estate, bitcoin, public securities, life insurance, lottery tickets or a mine on the other side of the world. In contrast, mutual funds are limited to investing in publicly traded securities, i.e. stocks and/or bonds.

What is a prop shop vs hedge fund? ›

Hedge Fund vs. Prop Trading. Hedge funds invest in the financial markets using their clients' money. They are paid to generate gains on these investments. Proprietary traders use their firm's own money to invest in the financial markets, and they retain 100% of the returns generated.

What is the difference between a hedge fund and asset management? ›

The only goal for asset management is to provide strong returns for the portfolio of assets as a whole. A hedge fund, while similar, is a collection of investment oversight that seeks greater returns through very risky types of investments.

Do prop traders make money? ›

Prop traders are not usually paid an hourly wage or salary and do not receive benefits such as health care. They are typically only paid when they generate a profit, which can take months.

Can hedge funds be market makers? ›

As banks step back from some traditional roles, hedge funds and other non-bank entities are stepping forward as market makers, enhancing liquidity and market efficiency.

How does prop trading work? ›

Prop trading firms invest their own capital to make profits, rather than using their clients' money in the traditional way hedge funds or investment banks would. As a prop trader, you can take part in the profits the firm makes without risking your own capital.

How are mutual funds and hedge funds similar how are they different quizlet? ›

Both traditional mutual funds (as opposed to index funds) and hedge funds are actively traded. This means that the portfolio managers are buying and/or selling securities on a daily basis. Hedge funds always offer performance incentives, it is much less common among mutual funds.

What are the key differences between mutual funds and hedge funds quizlet? ›

Mutual fund activities are more transparent and provide a list of the assets that the particular mutual fund owns. Hedge funds are generally less regulated and take more risks for higher returns.

What is the difference between a hedge fund and private equity? ›

Key Differences Between Private Equity and Hedge Funds

Private equity funds invest in companies that can provide higher profits over a more extended period. In contrast, hedge funds are used to invest in assets that yield good ROI or return on investment over a shorter period.

Why are they called hedge funds? ›

The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk. Early hedge funds sought to hedge specific investments against general market fluctuations by shorting the market, hence the name.

What defines a hedge fund? ›

A hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns.

What are hedge funds in simple terms? ›

Put simply, a hedge fund is a pool of money that takes both short and long positions, buys and sells equities, initiates arbitrage, and trades bonds, currencies, convertible securities, commodities and derivative products to generate returns at reduced risk.

What is a prop trading fund? ›

Proprietary trading, or “prop trading,” occurs when a financial firm or commercial bank uses its own money — and not that of its clients — to trade stocks, bonds, mutual funds or other securities. In other words, the firm puts up their own funds to earn a profit instead of relying on client fees and commissions.

Is prop trading legal? ›

The very short answer is no, proprietary trading is not illegal, unless you are a trader at one of the large banks. Thanks to the billions of dollars of losses they suffered during the 2008 financial crisis, banks are no longer allowed to proprietary trade.

Is Jane Street a hedge fund? ›

Jane Street Capital is a proprietary trading firm in NYC . This means that they trade with the firm's internal assets. This is not technically a hedge fund.

What is the biggest hedge fund in the world? ›

1. BlackRock Advisors. BlackRock (BLK) is a New York-based investment manager that manages trillions in assets. The largest BlackRock entity, BlackRock Fund Advisors, has been in operation since 1984 and oversees $1.9 trillion in assets.

What is the most successful hedge fund? ›

Bridgewater Associates

Bridgewater is the world's largest hedge fund, with about $150 billion in capital. Since its founding in 1975, Bridgewater has returned $52.2 billion in gains to its investors – more than any other hedge fund on the planet.

Is hedge fund an asset class? ›

Hedge funds are not a single asset class. With their light levels of regulation, hedge funds can invest across a wide range of asset classes and instruments, without the constraints that many public or mutual funds must adhere to. Hedge funds do not invest in a consistent way.

What strategies do prop traders use? ›

Key Takeaways. Proprietary traders may execute an assortment of market strategies that include index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, technical analysis and/or global macro trading.

What percent do prop traders make? ›

Proprietary trading firms typically have two model types or a slight variation on them: The firm takes a cut of your profits, anywhere from 20% to 50%.

How much do top prop traders make? ›

Salary Ranges for Prop Traders

The middle 57% of Prop Traders makes between $203,679 and $400,084, with the top 86% making $793,331.

Can anyone start a hedge fund? ›

Starting a hedge fund is not for just anyone with a good hedging strategy. It's likely you'll need startup capital in the tens or hundreds of thousands of dollars, plus a hedge fund attorney. Also, your strategy and how it performs in the current market conditions may determine the success of your hedge fund.

How much leverage do hedge funds use? ›

The average net leverage of hedge funds is 0.59 and average long-only leverage is 1.36. The raw volatilities of net leverage and long-only leverage are 0.28 and 0.38 respectively, which are significantly lower than the volatility of gross leverage.

Who are the biggest market makers? ›

Citadel Securities is an American market making firm headquartered in Miami. It is one of the largest market makers in the world, and is active in more than 50 countries. It is the largest designated market maker on the New York Stock Exchange.
...
Citadel Securities.
TypePrivate
Websitecitadelsecurities.com
9 more rows

Do investment banks still prop trade? ›

The simple part: Banks are banned from engaging in prop trading. The complex part: That ban is subject to several exemptions intended to allow banks to facilitate customer trading and hedge their own risks.

How do I start a prop trading firm? ›

1) Firstly, there should be minimum two persons to start a LLP. You can not start a LLP as "proprietary" trading firm. 2) For trading in stock market with one's own money there is no requirement of forming any company/LLP, you can very well do these activities in your own name and generate income/profits.

How does FTMO make money? ›

The FTMO Account is connected to our Proprietary Trading Firm's account where we generate cash flow. . If you generate profits on the FTMO Account, our Proprietary Trading firm will keep from 10% to 20% as the Profit Split, and you will be rewarded with up to 90% of achieved profits.

What are some important differences between mutual and hedge funds? ›

Mutual funds are regulated investment products offered to the public and available for daily trading. Hedge funds are private investments that are only available to accredited investors. Hedge funds are known for using higher risk investing strategies with the goal of achieving higher returns for their investors.

Why would it be challenging to properly compare the performance of an equity fund to a fixed income mutual fund? ›

Why would it be challenging to properly compare the performance of an equity fund to a fixed-income mutual fund? 1. Equity funds and fixed-income funds contain different types of securities. (a) Equity funds invest primarily in the common stock of publically traded firms.

What are two advantages of bonds for their issuers? ›

Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns. Interest rates on bonds often tend to be higher than savings rates at banks, on CDs, or in money market accounts.

What are the key differences between investment banks and commercial banks? ›

Commercial banks accept deposits, make loans, safeguard assets, and work with many different types of clients, including the general public and businesses. Investment banks, on the other hand, provide services to large corporations and institutional investors.

Is a REIT an investment fund? ›

REIT vs.

Non-traded REITs are private real estate investment funds that are professionally managed and invest directly in real estate properties and are not listed on stock exchanges. These are available only to accredited, high-net-worth investors and typically require a large minimum investment.

How has the perception of hedge funds changed since the financial crisis? ›

How has the perception of hedge funds changed since the financial crisis? The perception of "absolute returns" was partially invalidated by significant losses and investor withdrawals increased substantially as a result.

Who makes more money PE or hedge fund? ›

Hedge fund compensation is more variable than private equity salaries + bonuses, but at the junior levels, you'll most likely earn a bit more in private equity. At the top levels, a star hedge fund PM who has a great year could easily earn more than an MD in private equity – depending on the fund size and structure.

Is Berkshire Hathaway a hedge fund? ›

Answers: No. Technically speaking Berkshire Hathaway is not a hedge fund, it is a holding company. Although Berkshire operates similarly to a hedge fund in terms of investing in stocks and other securities, it does not take performance fees based on the positive returns generated every year.

Is BlackRock a hedge fund? ›

BlackRock manages US$38bn across a broad range of hedge fund strategies. With over 20 years of proven experience, the depth and breadth of our platform has evolved into a comprehensive toolkit of 30+ strategies.

Who regulates hedge funds? ›

Many hedge funds operating in the U.S. are also regulated by the Commodity Futures Trading Commission (CFTC), including advisers registered as Commodity Pool Operators (CPO) and Commodity Trading Advisors (CTA).

What kind of asset is a hedge fund? ›

Hedge funds hold a wide variety of asset types which can include derivatives, currencies, and real estate, in addition to equities and fixed income instruments. Investors in hedge funds can face limitations on redemptions of shares, which differs from the daily redemption requirements of mutual funds.

How do hedge funds make money? ›

Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.

Who can buy hedge funds? ›

Anyone can invest in a hedge fund as long as they meet the requirements. These conditions include having a net worth of $1 million or more, or earning at least $200,000 within the current year. Again, most hedge fund investors are individuals with substantial wealth.

Are hedge funds high risk? ›

High-Risk. In general, hedge funds are considered to be high-risk investments because of the huge potential for money loss. Again, these funds are primarily controlled by hedge funds managers, and with pools of money going into investments, there is likely going to be some loss.

How do hedge funds keep stocks down? ›

Hedge funds have an incredible supply of short shares available to borrow. This advantage has allowed them to manipulate a stock's share price by initiating short-ladder attacks. While supply and demand are pushing a stock's price up, hedge funds short the stock using an insane amount of leverage.

What is the purpose of hedge? ›

Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging requires one to pay money for the protection it provides, known as the premium.

Why hedging is not allowed in US? ›

The primary reason given by CFTC for the ban on hedging was due to the double costs of trading and the inconsequential trading outcome, which always gives the edge to the broker than the trader. However, as far as Forex trading is concerned, a trader should have the freedom to trade the market the way he sees fit.

How do hedge funds buy stock? ›

After a share-exchange transaction is announced, the hedge fund manager may buy shares in the target company and short sell the buying company's shares at the ratio prescribed by the merger agreement. The deal is subject to certain conditions: Regulatory approval.

What is a prop trading fund? ›

Proprietary trading, or “prop trading,” occurs when a financial firm or commercial bank uses its own money — and not that of its clients — to trade stocks, bonds, mutual funds or other securities. In other words, the firm puts up their own funds to earn a profit instead of relying on client fees and commissions.

What is the difference between hedge funds and private equity? ›

Key Differences Between Private Equity and Hedge Funds

Private equity funds invest in companies that can provide higher profits over a more extended period. In contrast, hedge funds are used to invest in assets that yield good ROI or return on investment over a shorter period.

What is Prop funding? ›

Proprietary Trading (or Prop Trading) is a type of trading activity employed by banks or other financial institutions that take advantage of non-client-related trading practices meaning they invest their own money rather than their clients' money to profit from short-term price changes in asset markets.

Is Jane Street a hedge fund? ›

Jane Street Capital is a proprietary trading firm in NYC . This means that they trade with the firm's internal assets. This is not technically a hedge fund.

What strategies do prop traders use? ›

Key Takeaways. Proprietary traders may execute an assortment of market strategies that include index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, technical analysis and/or global macro trading.

How does prop trading work? ›

Prop trading firms invest their own capital to make profits, rather than using their clients' money in the traditional way hedge funds or investment banks would. As a prop trader, you can take part in the profits the firm makes without risking your own capital.

Do banks still prop trade? ›

The simple part: Banks are banned from engaging in prop trading. The complex part: That ban is subject to several exemptions intended to allow banks to facilitate customer trading and hedge their own risks.

What is the biggest hedge fund in the world? ›

1. BlackRock Advisors. BlackRock (BLK) is a New York-based investment manager that manages trillions in assets. The largest BlackRock entity, BlackRock Fund Advisors, has been in operation since 1984 and oversees $1.9 trillion in assets.

Who owns a hedge fund? ›

Hedge fund management firms are often owned by their portfolio managers, who are therefore entitled to any profits that the business makes. As management fees are intended to cover the firm's operating costs, performance fees (and any excess management fees) are generally distributed to the firm's owners as profits.

What is hedge fund example? ›

Some examples of hedge funds include names like Munoth Hedge Fund, Forefront Alternative Investment Trust, Quant First Alternative Investment Trust and IIFL Opportunities Fund. There are others such as Singlar India Opportunities Trust, Motilal Oswal's offshore hedge fund and India Zen Fund.

Does Goldman Sachs do proprietary trading? ›

Goldman has said that as much as 10 percent of its revenue comes from proprietary trading, but some analysts believe that figure is based on a narrow definition of “proprietary trading.” Banks typically have traders on proprietary desks that trade with multiple banks using the firm's money.

How do prop traders get paid? ›

How does a prop trader make money? Most prop traders make money by taking a share of the profit they make by executing trades. The returns are multiplied due to the additional capital poured in by a trading firm. Many firms offer a fixed salary and a bonus component based on performance.

Who is the largest market maker? ›

Citadel Securities is an American market making firm headquartered in Miami. It is one of the largest market makers in the world, and is active in more than 50 countries. It is the largest designated market maker on the New York Stock Exchange.
...
Citadel Securities.
TypePrivate
Websitecitadelsecurities.com
9 more rows

Is five rings a market maker? ›

Five Rings is a proprietary trading firm founded with a vision of combining strategy, innovation and technology to succeed in today's global markets. Five Rings trades in various domestic and international markets, both established and esoteric.

Is Two Sigma a hedge fund? ›

Two Sigma Investments is a New York City-based hedge fund that uses a variety of technological methods, including artificial intelligence, machine learning, and distributed computing, for its trading strategies.

Videos

1. What’s the difference between a hedge fund and managed account
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2. Hedge Funds vs Asset Management - Are they different?
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3. What Is Prop Trading | How Prop Trading Works 2022
(Pip Bandits)
4. FTMO VS The Prop Trading Direct Comparison | Which Should You Choose?
(Trade Connect VVS)
5. Breaking into the world of hedge funds (and long-only) [interview]
(Coding Jesus)
6. Differences between Retail Traders vs Professional Traders that make money consistently
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