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.

Hedge funds are a type of investment vehicle usually open only to wealthy people and institutional investors. Proprietary trading refers to a financial institution making investments using its own funds, not client funds. Both hedge funds and proprietary trading can be lucrative, but they're usually off limits to average investors. Some banks have spun off proprietary trading operations as hedge funds due to regulation.

How Hedge Funds Work

The term "hedge fund" comes from a practice by some of the earlier such funds of hedging their bets with carefully chosen investments so they would lose less money if market conditions suddenly changed. Not all hedge funds today still stick to that practice, and now the term essentially refers to any fund with limited access to investors that makes money based on both the amount of money managed and the rate of returns.

Hedge funds don't just limit who can invest in order to be elitist. By restricting hedge funds to people legally called "accredited investors," they can be subject to less regulation than other investment funds. Generally, these investors have to be people making at least $200,000, people who have at least $1 million in assets or companies with at least $5 million in assets. The lack of regulation gives hedge funds more latitude in pursuing a wide range of hopefully lucrative investment opportunities.

Hedge funds also typically charge investors based on both the amount of assets under management and each year's return. A typical fee is 2 percent of assets and 20 percent of returns. If hedge funds beat other opportunities by enough, investors will still be happy to pay these fees.

Proprietary Trading

Proprietary trading refers to a financial firm investing its own money rather than money supplied by clients. This is usually handled separately from trading done on behalf of clients to avoid creating a conflict of interest, though the proprietary trading arm of a firm can come in handy if a client wants to trade something relatively obscure that is already owned.

After the 2008 financial crisis, when some banks seen as critical to the economy lost a lot of money through proprietary trading, Congress passed what's called the Volcker Rule as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. That rule limits the risks banks can take in proprietary trading, including some of their dealings with organizations like hedge funds.

As a result of the rule, some banks spun off their proprietary trading operations as hedge funds, and some bank employees working in the field left for hedge fund jobs.

 

About the Author

Steven Melendez is an independent journalist with a background in technology. He has written for a variety of publications and was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.

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