Hedge Fund vs. Proprietary Trading

Some big banks redirected their prop-trading operations to separate asset-management businesses.

Some big banks redirected their prop-trading operations to separate asset-management businesses.

If you've ever been given a corporate credit card, you know that you're spending your company's money for corporate purposes. This differs, of course, from your own personal credit cards, which you're responsible for paying each month. That pretty much sums up the difference between hedge funds and proprietary trading. Hedge fund traders use clients' money to invest in the financial markets and are paid to earn them returns, while proprietary traders use their employers' funds to invest and earn profits for the firm. However, prop traders are a dying breed, so it could be challenging to pursue a career in this field.

Hedge Funds

Hedge funds operate under the alternative investment category. They charge higher fees than more traditional professionally managed funds, such as mutual funds, and as such set out to generate alpha, or returns that are higher than what the broader markets are delivering. Unfortunately, they're not always successful. In the first half of 2013, hedge funds generated returns of less than 5 percent while the S&P 500 produced returns of more than 12 percent, according to hedge fund research firm Hennessee Group.

Proprietary Trading

Proprietary trading, also known as prop trading, occurs when a bank uses its own assets and cash to invest in the financial markets to strengthen its balance sheet. What prop traders are buying or selling — such as stocks, bonds and commodities — isn't the defining factor as much as whose behalf the traders are acting upon. As an investor, you can't benefit directly from prop trading because it doesn't include activity performed on behalf of any clients.

Regulation

Following the financial crisis of 2008 and 2009, both hedge funds and proprietary traders were scrutinized for escalating the market conditions. Both faced increased regulation as a result. Hedge funds (which are known for being secretive) that oversee at least $150 million became required to register their funds with the U.S. Securities and Exchange Commission, divulging details about their strategies in the process. Regulators and politicians frowned on large financial institutions trading solely for their own benefit rather than for the benefit of individual investors, causing firms including Citigroup and Goldman Sachs to shutter their prop desks altogether, according to a 2012 article on The New York Times website.

Overlap

Incidentally, the skill set for hedge fund and prop-desk trading is quite similar. Both trade sophisticated financial securities hunting for profits. Consequently, when regulators forced banks to stop trading their own money, many of these professionals went to hedge funds or launched new funds of their own. You won't hear about all of them because some of these hedge funds failed. For instance, one former prop trader who launched his own $2 billion hedge fund in 2010 was forced to close the fund after performance languished and the size of the fund dwindled, according to a 2013 article on the Forbes website.

 

About the Author

Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.

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