Among different ways to invest across the board, hedge funds and prop trading are common standouts. However, due to their complex nature new investors and readers are sometimes having trouble understanding these investment vehicles. That is why we decided to go into depth about Prop Trading Vs Hedge funds.
Prop trading firms use their own capital to trade it on the market by employing traders. On the other hand hedge funds pool investor's capital to invest into securities. While hedge funds invest external investor's capital, prop trading companies rely on their own capital.
Already from the most basic definition, these two are significantly different from each other. They offer investment opportunities to different types of clients, have different earning potentials, and utilize different investment approaches. Stay with us and by the end of the article, you will better understand these financial instruments.
Key Takeaways
- Prop trading firms aim to invest their own money to generate higher gains. They employ experienced traders who gain access to the company's capital that is provided for investing. The gains from trades are divided between companies and traders.
- While hedge funds often combine short and long-term investing, prop firms mostly rely on short investing horizon.
- Hedge funds that pass a certain AUM threshold have to be registered with the SEC. Prop trading firms on the other hand in most cases don't require any type of registration.
- Hedge funds are under detailed scrutiny from the regulatory bodies, while prop traders avoid this type of attention. This is the case because hedge funds use other people's capital to invest in assets, while prop firms use only their own capital.
Defining Hedge Funds And Prop Trading
What Is A Hedge Fund
Hedge fund is an investment vehicle that pools capital from accredited investors. Accredit investors come from either individual or institutional niches and are reserved for high-net-worth investors.
Every hedge fund is unique in its operations due to numerous strategies and risk management approaches. The most popular investment strategies include long/short equity, global macro, event-driven, and high-frequency trading.
Hedge funds aim to generate profits well above the indexes, by focusing on alpha generation. To accomplish this their strategies are often risky and include heavy reliance on leverage. Also, hedge funds use a controversial investing approach called shorting, which was covered in depth in one of the Hollywood blockbusters "The Big Short".
One of the issues of a hedge fund is often lower liquidity, due to strategies that focus on investing in debt, real estate, and private equity. In those situations, investors are dealing with long-term capital locking, which cannot be redeemed for years.
Due to often complex, and aggressive strategies that involve a lot of risks hedge fund managers pay great attention to managing risk. Some of the strategies include hedging positions, creating highly diversified portfolios, and setting stop/loss orders.
The Key Features Of Prop Trading
Prop trading firms are financial institutions that use their own capital to trade. This investment strategy tends to be risky, because in case of a downturn, the prop trader is taking the whole hit, and the loss impacts its bottom line. On the other hand in case of successful trades, they reap all the benefits. Companies are opting for this type of investment because they want to generate profits that are above low market margins.
Unlike hedge funds, prop firms do not work with external investors and solely rely on their own capital. Prop traders even more than hedge funds rely on leverage. Their investments are heavily amplified by borrowed capital, and as a result, their market exposure is much higher. This way they exponentially can increase their gains.
Prop firms often use sophisticated algorithms combined with high-frequency trading systems. This approach allows them to conduct trades at lightning speeds making the most of the current market inefficiencies.
Prop traders in collaboration with advanced trading systems analyse real-time data to pinpoint current trends before many others manage to profit out of them.
Most prop trading firms use a variety of strategies. On the list of most popular investment strategies are arbitrage, market making, directional trading, and statistical analysis. We will talk about them in depth later. Prop traders have the liberty that many investment vehicles, like hedge funds, do not have, and that is flexibility.
Other investment funds are often limited by their clients and cannot switch from investment approaches, and change goals "on the fly" like prop traders. This allows experienced traders to better exploit current market volatility and inefficiencies to earn extra gains.
While hedge funds invest in both short and long-term, proprietary trading firms focus more on short-term gains. High-frequency trading as one of their trademarks aims to benefit from short-term trading goals. Most of their trades fit in the time frame between milliseconds and a couple of days.
Most prop trading companies keep their operations under a veil of secrecy. The algorithms and techniques that they use are their competitive advantage.
Hedge Fund Investment Strategies
One of the distinct advantages of hedge funds is their diversity in investment strategies. Many hedge funds combine different strategies to achieve consistent returns. The historically first strategy that the hedge funds used was the long/short equity. Through it hedge funds aimed to maximize returns nonetheless of the direction that the market is going through.
With time new strategies were added, like global macro. This strategy focuses on earning from dislocations caused by global events. Wars, economic or social crises, or elections, are just some of the events that can trigger market volatility that can be exploited for maximizing returns.
Another popular approach is trend following which is aimed at capitalizing on the momentum of the market trends. The traders are looking to earn extra gain by selling the assets that are falling and buying those that are gaining value. Managers are following the theory that markets from time to time show a trend of sustained movements in one direction. Once they identify these trends, they can follow them and achieve positive gains.
One of the top strategies used by hedge fund managers is activist investing. Hedge fund managers take significant positions in companies aiming to claim positions on their boards. Once they do manage it, the hedge fund works on adjusting the company's strategy in a manner to maximize its operational efficiency and generate the highest possible surplus.
Like global macro strategy, event-driven strategy aims to exploit trends, and in this case, company-level events are primary triggers. Bankruptcies, spin-offs, and restructurings are among these events that can result in short-term price volatility which prop traders search to exploit.
Short trading is one of the scrutinized strategies that hedge funds employed through the decades. Hedge funds that employ this strategy are practically betting against the company. Once they identify that a company is overvalued and that it will lose value, they borrow their stocks from a broker. Managers immediately sell the stock and then wait until the price falls. Once it does they buy the stock at the lower price and return it to the borrower. This way they earn from the difference in price between the selling of the borrowed stock, and returning the stock to the borrower.
Prop Trading Strategies
Prop traders often opt for quantitative strategies including statistical arbitrage, quantitative trading, and high-frequency trading strategies.
Besides those, they also employ market-making approaches. This strategy is based on offering liquidity to the market by offering buying and selling prices for different types of securities. Like hedge funds prop firms also use global macro and event-driven strategies.
On the long list of strategies that prop trading firms use there are also directional trading and relative value trading. Directional trading emphasizes placing bets against the direction of the market or a specific asset. Relative value trading involves identifying price discrepancies between assets and betting that they will meet up at some moment.
Regulatory Differences
Hedge funds in the United States that have at least $100 million in assets under management may elect to register with the SEC under the Investment Advisers Act of 1940. Depending on the type of trading activities the fund utilizes, and the size of its AUM, it may need to file several forms.
Typically hedge funds on a quarterly level file a 13F form disclosing hedge fund holdings in the United States. In the form are contained investments into publicly traded equities and equity-related securities. They still do not need to show short positions, though.
Funds that partake in activist strategies usually need to fill out form 13D/13G for holdings with more than 5% of holding rights. Another important filling form for every hedge fund is a PF form. Through it, the fund discloses its risk profile, including the level of leverage and liquidity.
Besides those, hedge funds in the United States are subject to Anti-Money Laundering and Know-your-customer regulations. Through it, hedge funds must show the identity of their investors, and also monitor any suspicious activity like money laundering.
On the other hand prop firms in most cases don't need to register with any regulatory body. The reason behind this is that they are not using external investor's money for investing, but they execute trades with their capital.
While hedge funds are considered to have a low level of transparency in comparison to mutual funds, prop traders have even less responsibility to the public. They do not need to disclose their activities, strategies, risk management practices, or even performance. They are regulated through their internal policies, market, and trading rules, rather than a broader regulatory framework.
Type Of Clients
Hedge funds are highly dependent on their clients, unlike prop firms. They deal with high-end individual and institutional investors. One of the main hedge fund characteristics is that they only work with accredited investors. Often pension funds, mutual funds, and other elements from the financial system become investors in a hedge fund.
To become an accredited investor one must check one of two boxes. Either to have a net worth of at least $1 million or to have an annual income of at least $200 thousand ($300 thousand in case the client is in marriage).
Recently, to open hedge funds to a wider public, regulatory bodies allowed experienced investors an option to gain the status of accredited investor. This deletes the high wealth threshold which was keeping the majority out of the chance to ever invest in a hedge fund.
Prop firms on the other hand operate completely differently. They do not need to cooperate with clients and keep in line with client's wishes and the company's strategies. They use the capital from the firm itself and invest it into a financial market.
Potential Gains From Hedge Funds And Prop Trading
Depending on the fund, and the market conditions during the year, best-performing hedge funds deliver double digital annual returns. Exceptional-performing hedge funds can even go as far as 20% to 30% gains. More realistically hedge funds can deliver high single-digit returns or those in the lower teen range.
Prop firms depending on the success of the strategy can generate over 30% annual gains. Since they are often using leverage, in case of successful trades gains are heavily boosted. Since prop traders are using the firm's capital strategies can be scaled up to generate higher absolute returns.
Performances During Different Market Conditions
In bull market conditions when asset prices are on the rise hedge funds that emphasize growth strategies and leverage can perform exceptionally well. Strategies that fare best in the bull market are long/short equity, global macro, and growth investing. In these conditions, additional leverage can significantly boost gains.
Just like hedge funds, prop firms can use leverage to reap extra benefits from the upward market direction. In the case of prop firms, momentum trading, and market making proved to be amongst the best-performing strategies in the bull market conditions.
On the other hand, when the market is in the decline, and the bear market is dominating, event-driven and distressed debt strategies have the potential to outperform when hedge funds use them properly.
Hedge funds during a bear market often rely on hedging strategies to protect holdings from downside risks. Long/short equity funds can opt to reduce exposure or increase short positions, while global macro funds can reinvest capital into bonds or currencies that can benefit from a market downturn.
While proprietary trading firms are focused on short-term trades they can still perform well in these market conditions by exploiting volatility and fast-paced price movements. But, in case a prop firm is in the world of long investing, it may suffer significant losses during bear market periods.
In times of higher volatility, both hedge funds and prop companies can go either way - they can win or lose big. Hedge funds that emphasize their work on volatility arbitrage or similar strategies can benefit from these conditions on the market. Risk management strategy is crucial in these times, no matter the strategy the fund is using.
Regarding prop traders and volatile markets, those specialized in high-frequency trading, scalping, and arbitrage can substantially profit from short-term volatility. These strategies can bring a lot to the table if the trader catches price discrepancies at the right moment.
Final Thoughts
If you are thinking about investing, and you are not sure about the specific investment vehicle you need to conduct due diligence. Hedge funds are reserved for high-net-worth individuals while prop trading companies are closed off for external investors.
Both hedge funds and prop firms offer their unique approach to trading. Hedge funds are known for their diversified approach that often employs higher risk, while prop traders are mostly sticking with short-term trades.
If you are still unsure which route to take, look at our other pieces on investment vehicles that may be more suitable for you. We in depth explained mutual funds, ETFs, and venture capital, and we are sure that you will find something that is fitting to your goals and strategy.